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Whatever happened to inflation?

Ahead of the Curve, July 11, 2017

Inflation has not picked up in the way that many of us expected. In fact, over the last three months, it has surprised on the downside.

  • In the U.S., core CPI, which excludes food and energy, has dropped from 2% in April to 1.7% in May.
  • In the Euro area, core CPI is slowly trending up, but at 1.1% is still way below the 2% target rate of the ECB.
  • The G7 has an average core inflation rate of only 1.4%, and this is trending down.
  • The U.K. is the only country in the G7 with an inflation rate over 2.5%—and that is largely to do with the sharp, post-Brexit drop in the value of sterling.

The U.S. inflation numbers are most surprising, given how far it is into an economic expansion and how low the unemployment rate remains.


Economists are mulling a range of possible explanations:

  • A weaker-than-expected oil price at $45 per barrel is down from $54 in February, due to excess production capacity. This does not affect the core measures of inflation quoted above, but it does impact the cost of living and the degree to which workers push for pay rises. It also reduces the costs of a wide range of manufactured products, including plastics. It also weakens aggregate demand via lower levels of investment in plant and machinery. I give this possible explanation a 3 out of 5 for plausibility.
  • A surge in productivity is finally taking place, after a decade or more of weakness. Although there is tendency for productivity to improve in the latter stages of an economic expansion, as labor becomes scarce, I have seen no hard evidence that this is occurring. So I give this a 1 out of 5 for plausibility.
  • Government statisticians are getting better at measuring the quality of goods and services in the technology sector. For example, when the price of a new model smartphone rises by 30%, but its memory, processing power and camera is 30% better, there is no inflation. The methodological improvements in inflation measurement, which are most advanced in the U.S., are not sufficient to account for the recent downside surprises, but there is something in this argument. I give it a 2 out of 5.
  • Unemployment is higher than the headline statistics suggest in the U.S. because of hidden unemployment, and is still quite large in the Euro area. U6—the U.S. government measure of broad unemployment1—was 9.4% in January but has dropped sharply to 8.4% in May. That is 1.6 million workers back in employment, with the potential for another 1.5 million to follow. The headline unemployment rate in the Euro area is 9.3%, with a cyclical low of about 7.5%. Potentially another 3.5 million workers are available. All things considered, I give this one a 4 out of 5.
  • Globalization, though much reviled, is alive and well and doing its work through Business Process Outsourcing (BPO). BPO is the process by which large corporations shift service sector jobs to lower-cost locations of equivalent skill. There are BPO hubs all over the world, but three English-speaking nations are worth mentioning here: India, the world capital of BPO; the Philippines; and, South Africa. The below figure shows how job growth in India’s service sector started to increase rapidly after about 2003, when BPO started to take off. I estimate that there are now at least 5 million in BPO industries, and the number is growing very fast. The Philippines is estimated to have 1.2 million workers in BPO, and South Africa 40,000 to 50,000. This factor gets a full 5 out of 5 from me as a plausible explanation for inflation not picking up.

Ahead of the Curve

What does it all mean for the macro economy and real estate?

Given the above, and a few other anti-inflation processes that are too complicated to mention, it is not that surprising that inflation is so subdued. But what does it all mean for economics and real estate?

  • Central banks should probably reset their inflation targets to 1% or 1.5% (but they won’t, because such a move would come under intense scrutiny from politicians);
  • Interest rates will continue to rise, because central banks will react to the level of unemployment (but the rise will be slow);
  • Lower-than-expected rises in interest rates will encourage risk behavior and preference for risk assets, suggesting that the end of the next cycle will be driven by an asset market event or a rise in bad debts;
  • Real estate yields and cap rates may fluctuate according to fundamentals, but have a solid anchor in low bond rates; and last, but certainly not least;
  • Investors who like office should head for India.

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1U6 is official unemployment (U3) plus part-time workers who would like to work full-time plus others that would like to work but are not looking for work or claiming benefit because they believe that there is no work available.

For more information about this report, please contact:

Richard Barkham, Ph.D.
Chief Economist, Global
+44 20718 22665