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Uncommon truths: The causes and course of inflation

The causes and course of inflation

Recent conversations with investors reveal a lot of confusion about what causes inflation and what the future path will be. We take a look at various explanations including a Malthusian view of long-term drivers, shorter-term views of more proximate drivers like commodities and wages (Phillips curve) and wrap it up with a broader monetary approach. All of those prisms suggest that we are witnessing an aggravated cyclical phenomenon and that headline inflation could fall surprisingly quickly. 

We all have a view on inflation but recent meetings suggest a lot of confusion about its origins and its future path. What we do here is to explore some basic economic concepts and give our view about whether inflation will rapidly come back down or whether it is now moving to a durably high level, perhaps matching the experience of the 1970s and 1980s. 

If inflation is defined as a process of rising prices (of commodities, goods, services, labour and assets) then it would appear to be ever present. I struggle to think of a period during my life (since the early 1960s) when at least some (if not all) prices have not been rising. 

Prices adjust to changes in the balance between supply and demand and tend to rise when there is excess demand. If we borrow from Thomas Malthus, in a world where population rises exponentially but the supply of raw materials (and especially food) increases in a linear fashion (due to the nature of productivity gains), there will eventually be a tension between supply and demand that leads to a rise in the price of the relatively scarce resources and/or goods. These “frictions” lead to constant changes in relative prices (some rising and some falling) but constant population growth lends an upward bias to the general price level. Hence, inflation tends to be positive. 

Of course, rising population suggests a continual increase in the supply of labour, which could depress the price of labour (wages).  However, labour markets have not been free for some time (due to unionisation, regulation and minimum wages etc.), which has made nominal wages sticky in the downward direction, though real wages can be reduced by inflation. Further, an uptick in population doesn’t impact the supply of labour for around 20 years but does immediately impact demand for goods and services due to the need to feed, clothe and house the expanded number of children.   

Hence, population growth in excess of productivity growth will tend to increase prices and inflation long before the additional workers can depress real wages. Indeed, Figure 1 suggests that the ebb and flow of global population growth over long periods of time is associated with fluctuations in the rate of inflation. The prime example is what happened after WW2 when an unprecedented demographic explosion led to an extended period of high inflation. The OPEC oil embargo of the 1970s may have been the proximate cause of that inflation but we believe it was only made possible by the tightening of commodity markets provoked by extreme population growth. 

However, we are now on the other side of that process. Though the world’s population is expected to continue growing, the rate of growth is forecast to move continually lower (and recent low birth rates reinforce that notion). Hence, inflation may face a long-term demographic headwind. 

Figure 1 – World population growth and CPI inflation in select countries (annualised 50-year changes, %)

Note: from 1260 to 2100 showing annualised rolling 50-year changes, based on annual data (inflation data is to 2021). For earlier periods, when population data is not annual, the data has been interpolated on a straight-line basis. Population projections are from the United Nations Medium Variant scenario. Source: Global Financial Data and Invesco.

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