14 to 20 August: Just a Minute

Last week, minutes to the ECB and FED July meetings revealed an increasingly agitated discussion about the lack of inflation associated with the current expansion and period of declining unemployment (the failure of the Phillips curve). We’ve highlighted our view many times that monetary policy has failed to properly recognise both declining potential growth in the developed world and its own role in propagating a vicious circle of inefficient asset allocation and increasing leverage.

Considering the Phillips curve specifically, it would be difficult to argue that the link between resource utilisation and inflation has completely broken (as slack reduces, there must be increasing price pressures as demand outweighs supply). However, the nature of this relationship (the slope, position and formulation of the Phillips curve) has never been stable through time and has clearly shifted over the past decade. Currently, we suggest the curve is extremely flat (there are very limited inflationary pressures) because of:

  • Mis-measurement, given ageing demographics and post financial crisis shifts in the labour market (for example towards part-time working), the headline unemployment rate may no long represent unemployment accurately.
  • Expectations, firms and investors have limited faith in the long-term sustainability of economic growth due to dynamics such as limited avenues for productivity growth, elevated leverage and the inability of policy to innovate (so called secular stagnation). We think this is the key explanation.
  • Technology, firms are losing pricing power due to “disruption” from technology.
  • Energy and Materials, economic growth is not leading to a demand/supply imbalance in the energy and materials sector due to a decade of China inspired investment in capacity.

Whilst these trends do not augur well for the long-term, over coming months they could continue to foster a positive environment for risk assets. Global growth is as strong and broad based as it has been since the financial crisis and, if the forces that would usually translate this into inflation and monetary policy tightening are weakened, the “Goldilocks” conditions of the last 12 months could prevail. Moreover, whilst our discussion above focuses on the developed world, emerging market central banks are biased to ease policy.

Of course, this is not to confuse resilience with complacency; our major risks to the outlook are political, particularly in the US.


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