One reason for thinking so is simply that overseas inflation is low. China’s slowdown is holding down commodity prices, which is already depressing UK prices. Figures next Tuesday could show that manufacturers’ input prices have fallen by six per cent in the last year, and thanks to this their output prices have barely risen at all since the summer.
What’s more, inflation is low and likely to stay so in our biggest trading partner. Consumer price inflation in the euro area fell to 0.5 per cent last month, and investors don’t expect it to rise much; French government bonds are pricing in an inflation rate of only 1.2 per cent a year between now and 2020.
There’s also one reason to expect domestically-generated inflation to stay low. It’s that labour productivity might be picking up. The ONS says that total hours worked rose only 0.1 per cent in the three months ending in January, during which time real GDP rose 0.7 per cent. This implies an annualized rise in productivity of 2.4 per cent, which – if it is sustained – would mean that the long stagnation in productivity is coming to an end. This matters. A pick-up in productivity growth would help depress unit wage costs which would mean that firms could hold prices down whilst maintaining decent profit margins.
History also points to low inflation. Inflation continued to fall for some time into the recoveries from the last two recessions – not least precisely because a pro-cyclical rise in productivity held down costs. In the 1980s inflation did not bottom out until the summer of 1986 – by which time real GDP was 20.4 per cent above its recessionary trough. In the 90s, inflation bottomed out in the summer of 1994, when GDP was 11.3 per cent above its recessionary low-point. However, real GDP now is only 6.3 per cent above its recessionary low. This suggests we’ve some way to go before worrying about inflation.
One argument against all this is that unemployment has already fallen sharply and that further drops would tend to raise wage inflation and hence price inflation. This argument, though, is weak. For one thing, the measured unemployment rate understates the excess supply of labour; there are 2.3 million people who are “economically inactive” who want a job – almost as many as there are officially unemployed.
And for another thing, recent history tells us not to worry about falling unemployment. Since 1997 there has indeed been a good correlation between the unemployment rate and CPI inflation in the following 12 months. But it’s been positive; lower unemployment has tended to lead to lower inflation, not higher. This could tell us that inflation has been driven more by supply shocks than demand one; lower commodity prices or faster productivity growth allow both inflation and unemployment to fall. Or it might remind us that, in an open economy, there are a range of unemployment rates consistent with low inflation. Whatever the reason, falling unemployment in itself is insufficient reason to expect inflation to rise.
There is, though, another argument to expect inflation not to fall. It’s simply that the Bank of England is targeting inflation, so the prospect of low inflation should mean that it runs an easier monetary policy in an effort to raise inflation.
Personally, I’m not sure how much control central banks have over inflation. And it's possible the Bank might raise interest rates even if inflation stays low simply as it tries to normalize monetary policy.
But perhaps investors don’t need to worry much about this. For years, low inflation has been good for equities; there’s been a strong correlation between dividend yields and the inflation rate. If this remains the case, there’s a reason to expect good gains on shares.
