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Analysis
Bear market risks stagflation

Bear market risks stagflation

Generation gap and cost-push inflation

by Brian Reading in London

Fri 7 Apr 2017

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The UK Office for National Statistics reports that in 2015 death rates increased by 5% for women and 3% for men compared with the previous year. Although blamed on national health and social care spending cuts for the old, the statistic signals a change in trend with long-term consequences for inflation and bond markets. The aged bond bull market is nearing its end. The young bond bear could also be long-lived with a return to stagflation in the late 2020s – bringing intractable policy dilemmas for government.

Inflation is either demand-pull or cost-push. Cyclical inflation is demand-pull. The rate of inflation increases when demand exceeds potential output and/or unemployment falls below the non-accelerating inflation rate of unemployment. The late Norman Macrae, deputy editor of The Economist, described demand-pull inflation as ‘too much money chasing too few goods’. Milton Friedman followed with his famous dictum, ‘Inflation is always and everywhere a monetary phenomenon.’

Excessive inflation can always be beaten by restricting the money supply, a truism based upon a tautology, also known as the ‘quantity theory of money’. It is appropriate when applied to demand-pull inflation. But when applied to cost-push inflation, it presents a policy dilemma. The choice is between validating inflation to save jobs, or negating it, causing higher unemployment.

Cost-push inflation is secular. It is caused by too many claimants chasing too little income. At each peak and trough in the demand cycle, inflation and unemployment are higher. Cost-push inflation crowds out the weakest claimants, which depresses consumption and investment. This leads to slower growth and rising unemployment.

Cost-push inflation leads to long bear and shorter bull bond markets. A long bear market peaked at the end of the 1970s as inflation hit record levels. From the mid-1950s competing claims on income escalated, and government spending as a share of nominal GDP rose. Low unemployment, especially compared with the 1930s, strengthened labour bargaining power.

At the outset cost pressures were domestic. They were exacerbated in 1970 by the first oil price explosion and the collapse of the Bretton Woods fixed exchange rate system. Savers and profits suffered. Policy-makers, except those in Germany, initially chose to validate inflation to protect jobs. Keynesian fiscal ease forced monetarist stringency until record unemployment curbed inflation.

The effects of globalisation prolonged the subsequent bond bull market. The opening of China and fall of communism expanded cheap labour and depressed product prices, causing a global savings glut. This, in addition to advances in technology, led to a rebalancing of international labour costs.

Unskilled workers in advanced economies suffered as a result. Clerical jobs disappeared. Quantitative easing and record low interest rates precipitated too much credit chasing too many goods. Asset price inflation was the remedy for product price deflation, at the expense of increased inequality. Demand-inflation is temporarily replacing cost-deflation, leaving a toxic legacy from normalisation.

Increasing mortality rates are a recent trend change. Demographic forecasts will be revised, accelerating the rising ratio of older dependents to younger workers. Rising mortality reflects life style changes as well as economic and psychological pressures on the lower working class. The British Medical Association reports that three-quarters of people who suffer heart attacks lack exercise. Around 20m Britons are physically inactive. An abundance of junk food worsens circumstances.

A smaller labour force is supporting a larger ‘idle force’. The older generation, more numerous and politically more powerful, demands increased public spending on health, welfare and pensions to stay ahead of price increases. The less numerous working population makes economic demands to protect wage-income shares. As was the case at the beginning of previous long bear markets, too many claimants are again chasing too little income.

Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.

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