Why inflation remains low (Hint: It's about technology)
22 Jul 2019 /
Joseph H. Davis, PhD, is a Vanguard principal and the global head of The Vanguard Group, Inc.'s Investment Strategy Group.
Joseph H. Davis, PhD, is a Vanguard principal and the global head of The Vanguard Group, Inc.'s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics.
As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group, which oversees more than USD 700 billion in assets under management. He is a frequent keynote speaker on economic trends, capital market returns and investment strategies and has published several white papers on related topics, many in leading academic and practitioner journals.
In 2004 Mr. Davis was selected as a faculty research fellow of the prestigious National Bureau of Economic Research for his contributions to the fields of economic history and U.S. business cycles. Prior to Vanguard, he spent time as an economist at Moody’s Economy.com. Mr. Davis earned his BA summa cum laude from Saint Joseph’s University and his MA and PhD in economics at Duke University.
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When 2017 began, many economists in the U.S. expected inflation to accelerate. The labour market was tightening, and unemployment was low. But core inflation, which excludes volatile food and energy prices, registered just 1.9% year-over-year that April, down from 2.3% that January. Prices actually fell in March 2017, the first time U.S. consumer prices had dropped month-over-month since January 2010.
The situation then was unusual, but now, two years later, it's increasingly clear that inflation remains tame—significantly below the 2% annual target set by the makers of monetary policy in many developed nations.
Why is this happening, when the U.S. job market remains tight? And what does it mean for investors? To answer the first question, look no further than Moore's Law, which explains how ever-cheaper and ever-better technology reverberates through the U.S. economy.
Inflation has been falling short of the Fed's target
Notes: Core inflation is measured by the Core Personal Consumption Expenditures Price Index (which excludes food and energy). Data cover January 1998 through March 2019. Sources: Vanguard calculations, based on data from the U.S. Bureau of Economic Analysis, the U.S. Federal Reserve, and Thomson Reuters Datastream.
A closer look at Moore's Law
Moore's Law states that as technology improves, its relative price declines. The wholesale price of cell phones, for example, fell 13% in the United States in April 2017 from a year earlier. But Moore's Law (coined by Intel co-founder Gordon Moore) is about more than tech products. Its indirect effects restrain prices in every corner of the economy.
According to the U.S. Bureau of Economic Analysis, the amount of technology used in producing goods and services more than doubled from 1997 to 2017, from 8 cents per $1 of output to 17 cents. The impact has been most pronounced in tech-intensive industries such as information technology and communications, professional services, and manufacturing. But as the figure below shows, even sectors that may seem less directly tied to technology—such as health care, education, and retail trade—have seen significant cost savings.
Our research suggests that declining input prices for computers and electronic products, computer design and services, and other technology inputs trimmed almost 0.5 percentage point per year from production costs from 2001 through 2017 and ultimately from wholesale prices. Without Moore's Law, annualized U.S. inflation would have been almost 0.5 percentage point higher. Without technology's price-suppressing effects, core inflation would be at 2% or more, achieving the Federal Reserve's inflation target. The higher inflation that would have resulted would have forced the Fed to further raise interest rates.
Technology's effects on prices, by industry
Notes: Data cover January 2001 through December 2017. A basis point (bps) is one-hundredth of a percentage point. Sources: Vanguard calculations, based on U.S. Bureau of Economic Analysis input-output tables and Thomson Reuters Datastream.
Implications of low inflation for investors
Vanguard expects the U.S. inflation rate to remain subdued over the next ten years, with core inflation hovering around the Federal Reserve's 2% target. Modest inflation should help boost economic growth, as interest rates are likely to remain low.
And technology's role in dampening the effects of inflation should be mostly good news for bond investors, particularly retirees and others with relatively shorter time horizons. That's because lower inflation preserves the value of a bond's coupon payments, which remain fixed until the bond matures.
Low inflation should also support stocks, as lower input prices strengthen corporate profits. Persistently low inflation also restrains yields and makes less risky investments, such as money market funds, less attractive.
There is always a chance that materially stronger global growth, accommodative monetary policy, or economic shocks such as an all-out trade war could spur higher-than-expected inflation in the coming years. But we expect Moore's Law and the pace of technology innovation to remain an obstacle to central bankers' 2% goal.
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