What Happened to the Inflation that Never Showed Up?
When the global Central Banks started their aggressive QE programs, everyone was warning about hyper-inflation. But inflation has not occurred. Even more strikingly the Fed, the ECB or the BOJ cannot create enough inflation. This does not mean that inflation will not come at a much later time but let’s discuss why inflation has not occurred. In this article I want to illustrate that structural changes in labor, capital and information flow have changed market dynamics and affected inflation.
Over the past years global central banks have purchased different debt instruments and by that increased the money supply. Of course there are different measures of money supply (M0, M1, M2). One question commonly discussed in financial media is, if financial institutions did actually put that additional M0 supply in circulation by extending credit or if they just kept that money to improve their balance sheets. An important factor regarding money available for transactions is credit creation. Depending on the credit cycle the amount of credit in the US is on average almost four times higher than “real” money.
Data shows that since 2008 M0 money supply is up 4X while M2 money supply has almost doubled (M2 velocity has gone down and is at a multiyear low from its peak in 1997). Credit conditions have been difficult which had some effect on low inflation. But considering the unprecedented size of QE by all global central banks and the near zero or negative interest rates, credit has increased. The doubling of the M2 money supply clearly shows that additional credit was made available by these actions. Below are two charts that illustrate the evolution of both M0 and M2 money supplies.
In the US, many consumer-related measures, like consumer confidence or consumer comfort, have recovered significantly. Auto sales specifically have been booming and the housing market has recovered substantially. So consumers seem to be getting credit and spending. Business capital investing may still be less pronounced but we had couple of years of significant job growth which shows that businesses are spending more by expanding capacity. So what is happening to all that extra income and spending?
Let’s take a slightly different approach to inflation. Let’s take a bottom up approach that discusses how prices are set in a marketplace. For the simplicity of this analysis let’s assume that the central banks were able to increase the money supply, and that institutions created some amount of credit, so that consumers and businesses had more money to transact with than before QE.
Yet thinking that inflation is purely a function of money available is a very one-sided view of economics. Prices are set by broader market dynamics and market efficiencies. Money in circulation, which affects demand for products or services, is just a single component of that equation but the adjustment of the supply side to meet demand, and the pricing power of suppliers, are also two important factors. Let’s look more closely at these other factors that affect inflation.
For this analysis we will view the price of a product or service as comprising of two components
A. Cost (driven by a cost marketplace)
B. Profit (driven by a profit marketplace)
To understand how recent prices have evolved, we will discuss three continues structural developments related to labor, capital and information flow. Their interplay with each other has affected market dynamics and lowered both of the above-mentioned price components therefore hampered inflation (as measured by CPI or PPI). It is important to understand that the interplay of the three developments is crucial, since any one of them alone would have not led to the current outcome. These developments are:
1. Globalization
2. Abundant risk capital that fosters entrepreneurship/capacity expansion
3. The Internet
1. Globalization has made markets for labor and input resources (cost marketplaces) larger, more transparent and efficient.
a. Products and services sold in the US are produced by a larger and more competitive global market for labor. This puts downward pressure on labor cost. Since global labor markets can be tapped much easier now, there is more overall labor slack than is shown by a country’s unemployment rate. This could be one reason that there is little wage inflation although the US unemployment rate is close to 5%.
b. Through more open trade, the market for input resources has also become larger and more competitive, which puts downward pressure on resource prices. One resource, energy, is especially affected by technological disruption in the oil market. Even if the oil price effect on inflation is transitory, the currently more responsive resource markets can absorb increased demand much easier without an increase in resource prices.
Therefore globalization with its effect on labor and resource markets has decreased the input cost for many products and services.
2. Availability of risk capital because of low interest rates has led to a rise of global entrepreneurship and easier capacity expansion. This makes it harder for companies to create scarcity or a unique product that would give them pricing power. One can think of Uber being followed by Lyft , Didi or all the other copycats. One can also think of Samsung being followed by Xiaomi, Lenovo and Huawei. Unless a company can create a really differentiated product or service, it will be quickly followed by many other entrants with sufficient capacity/capital and be forced to compete on price.
Additionally, the low cost of capital may make it easier for companies that are less profitable to remain in the marketplace and keep the marketplace more competitive.
Availability of risk capital and rise of global entrepreneurship have made it easier for competitors to increase and maintain capacity to meet additional demand for products and services. This development leads to more competitors in the marketplace eventually lowering prices closer to input cost.
3. The Internet has created a more efficient and competitive marketplaces for products and services all along the value chain. Now we can easily compare prices between different vendors and choose the best price. We can order online and avoid the previous market friction of distance. These developments have eliminated information inefficiencies in the marketplace that in the past would have given a vendor more pricing power. Now for an undifferentiated product or service the vendors are forced to lower their prices much closer to the input cost by matching or coming close to the lowest price on the market. This development eats into profit margins.
One example of this is Amazon, which is in a price war with brick and mortar retailers and forces everyone to lower prices and reduce margins. Another example is Alibaba, where a distributor can compare and get quotes from multiple competing producers.
The Internet has created more efficient marketplaces and therefore led to a broad decease in profit margins for many undifferentiated goods and services all along the value chain.
These three developments have led to more freedom in labor, capital and information flow. By acting in interplay with each other they have change the dynamics of cost and profit markets. The new dynamics has hampered inflation (measured by CPI or PPI) that everyone expected after QE. To reiterate what happened to meet increased demand:
- Globalization has led to lower input cost
- Abundant risk capital has led to sufficient supply and more competitors
- Internet created a more efficient and competitive marketplace between these competitors
As a result prices have remained close to the low input cost!
The diagram below helps visualize the market dynamics of a single value step.
To summarize: Independent of the amount of money supply (which affects demand for products and services) as long as sufficient supply capacity can be created to meet additional demand (through abundant risk capital and global entrepreneurship) at low cost (through global production cost-markets) and with internet creating more efficient marketplaces (both on the cost and profit side), the prices will stay close to the low input cost and therefore remain low.
What would tip this equation?
- At some point input cost could go up due to the exhaustion of production resources (global labor/natural resources) or due to policy restrictions.
- Changes in capital markets can reduce availability of risk capital and lead to production capacity restrictions.
- Companies can increase switching cost by introducing more differentiation or creating ecosystems thereby gaining more pricing power.
As always in economics there are many additional factors that contribute to cost and pricing such as efficiency gains, pace of innovation or limits on highly skilled labor.
One could also further discuss factors that affect the demand side, such as the amount of money in circulation or the velocity of money. Another interesting factor to analyze would be globalization’s and internet’s effect on total demand.
However, in my opinion the three developments discussed in this article are a big reasons that the expected inflation has not shown up.
Since I am a dyslexic, I am prone to spelling and grammar mistakes. I hope that it does not distract from the substance of the article.
Thank you for reading this article
