with Walter Kemmsies
One concerning aspect of the economic recovery that is taking place in the United States and other major economies is that inflation has been running well below 2 percent, the target rate in both the United States and Europe. This has been discussed and analyzed extensively by the world’s major central banks, including the Federal Reserve, European Central Bank, and the Bank of Japan. This matters to the freight movement industry, because production and freight movement costs must be covered by the prices consumers pay for goods. If prices paid by consumers are not increasing then producers or at least some segments of the freight movement industry will struggle if costs are rising.
Some economists are concerned that low inflation means there is a risk of deflation occurring despite policymakers’ efforts. Some of this concern likely stems from Japan’s decades-long struggle with deflation. Deflation would be a serious problem for the freight movement industry, because there is no mechanism in contracts to lower costs or debt payments if prices or rates are declining.
With policymakers focused on keeping inflation close to 2 percent it is unlikely that deflation will occur. Nonetheless it is helpful to develop some perspective and monitor some trends.
Milton Friedman, who received a Nobel Prize in Economics, once said that “Inflation is first and foremost a monetary phenomenon,” meaning inflation is the result of too much money chasing too few goods. To understand inflation trends it makes sense to see what is happening in the financial sector.
When the financial sectors in the United States and Europe collapsed in 2008 their central banks and governments came to their rescue with bailout loans and started lowering short-term interest rates. The U.S. economy began to recover, but very slowly. To give the recovery a bigger boost, the Fed began buying long-term government bonds, particularly those with 10 years to maturity. The yield on 10-year Treasury bonds is very important, because it is used to set the interest rates on loans to companies and consumers, including mortgages. By buying bonds the Fed pushed prices up and therefore the yields down on the 10-year Treasury bonds, which lowered interest rates on loans to buy homes, autos and investments in plants, property and equipment.
Lending has increased but banks have not lent as much as they could have given the Fed’s efforts. Banks have been more sensitive about the credit quality of potential borrowers, especially for mortgages. It is likely that this has reduced the effectiveness of the Fed’s efforts.
In the United States, the core personal consumption expenditures price index (which excludes fuel and food prices) that the Fed focuses on has averaged 1.3 percent over the last two years. This is below the 2 percent level that the Fed recently announced as its official target.
No official reasons are given for the 2 percent target. Milton Friedman argued many years ago that central banks should aim to have the money supply grow 2 percent faster than real GDP so as to avoid deflation. This means that on average inflation should be 2 percent.
However, not all industries have the same inflation rate. Young industries such as technology tend to experience deflation following the introduction of new products when competitors emerge, which has also been the case with computers where prices have fallen 90 percent over the last 25 years. More mature industries have fewer competitors entering their markets, which makes it easier for them to pass on cost increases.
When inflation is running below 2 percent for the economy as a whole it is likely that the majority of industries, including freight movement, are struggling to raise prices and pass on cost increases.
It is possible that some long-term trends are combining in a way that weighs on inflation. In the 1970s, major developed economies had Baby Boom generations entering the labor market and establishing households. Demand for a wide range of goods was growing at a high rate. When the Oil Crises of 1973-74 and 1979-80 occurred, developed economies saw costs increase. Consumers had to pay ever higher prices to get fewer goods. Central banks responded by lowering interest rates, which stimulated demand. Inflation increased from 3 percent in 1970 to 7.5 percent in 1980 as prices grew faster than the production of goods and services.
Despite interest rates being lowered in Europe, the United States and Japan, inflation didn’t rise in these economies in the last five years like it did in the 1970s. Their populations are older and their demand for goods and services is unlikely to be growing like it was in the 1970s. These economies consume less energy per dollar of GDP now compared to the 1970s, so higher oil prices have not had the same impact on production costs as they did back then. Companies are investing in capital, particularly automation, which allows them to offer more goods and services at lower prices. Unlike the 1970s, prices have grown more slowly than output.
It seems that it would help if there was a lot more investment in expanding industries like agriculture, capital goods and energy that will supply growing world demand. This would create jobs and support consumer spending, which would offset the risk of deflation. Investment in infrastructure to support exports of these goods could thus remove a litany of economic risks.
Kemmsies is chief economist at Moffatt & Nichol, an infrastructure engineering firm. He can be reached at (212) 768-7454, or email at email@example.com.