Inflation - Dead or Hibernating

Inflation has flat-lined since the GFC. What impact will this have on long-term market rental growth and total returns?

22nd August 2016

Continue to the other two articles in this edition of the Global Outlook...

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Real estate equities are soon to be elevated to a dedicated industry class. What impact will the reclassification have on the sector? Cynthia Parpa, Director, Grosvenor Real Estate Securities Research, takes a look. Click here to read more.

Property is often considered an attractive inflation hedge, as rental growth exhibits a strong long-run correlation with price inflation in the broader economy. But what happens when inflation is persistently low? This article examines the conspicuous lack of inflation in the years following the Global Financial Crisis (GFC), where a number of structural changes have continued to keep inflation weak. If these changes persist, interest rates are likely to remain lower for longer and total return expectations should likewise be revised down.

Inflation has flat-lined since the GFC. One of the unusual features of the post-GFC recovery is the lack of inflation at a relatively advanced stage of the cycle. In the post-war period, inflation has generally risen towards the peak of the cycle as demand outpaces supply, to prevent shortages. A typical economic cycle lasts around eight years on average and it is eight years since the collapse of Lehman Brothers. Yet inflation across most advanced economies remains woefully short of central bank inflation targets (Chart 1). Since 2009, the OECD average inflation rate has been below 2% for 81 of the last 89 months (and averaged just 1.3% p.a.). 

The prolonged slump in inflation is now causing a sharp divergence among forecasters about its future. Most macroeconomic models continue to assume that inflation will soon return to its long run trend of just over 2% (e.g. IHS are forecasting US inflation to average 2.2% p.a. over the next five years). Financial markets, however, appear to have lost faith in policy-makers; the implied inflation expectations from bond markets have inflation over the next five years averaging just 1.3% p.a.

What determines inflation? So who is right? To assess the outlook for inflation, it is helpful to outline a basic economic framework for inflation. In the very long run inflation depends on a country’s money supply and is therefore ultimately anchored to the central bank’s policy objective¹. But in the short- to medium-term (i.e. over a three to five year horizon) inflation is more typically explained using an “Expectations-Augmented Phillips Curve”. This Philips Curve framework argues that current inflation is a function of two factors: (i) expected inflation and (ii) the amount of spare capacity in the economy (the output gap).

If there are any factors that prevent actual output growth from reaching its potential for an extended period, this will reduce inflation via the output gap. Furthermore, the longer that low inflation persists, the more it becomes self-reinforcing as low inflation expectations become embedded, which in turn reduces future inflation. Viewed from this perspective, there are several legacies of the pre-GFC era that still constrain aggregate demand, keeping output gaps wider than normal and eroding inflation expectations:

  • Deleveraging headwinds: The GFC was precipitated by a 30-year bull run in debt markets, underpinned by a sustained increase in debt levels. Private non-financial sector debt in advanced economies nearly doubled through this period, from around 87% of GDP in the early 1980s to around 170% in 2009. Since the GFC, households, companies (and to a lesser extent governments) have prioritised paying down debt to reduce leverage rather than fund new spending. This situation is sometimes described as a “balance sheet recession”, and looks to be one of the structural factors that have kept output gaps wide in recent years.
  • Weak confidence: Because of these continued deleveraging headwinds, we have not seen the typical above-average “take-off” rates of growth that normally accompany economic recoveries. Since the GFC, there have been several recurring bouts of economic pessimism. The unusual number of economic speed bumps in this recovery cycle has stunted a stronger rebound in confidence, which has help maintain a wider output gap and depressed inflation expectations.
  • Subdued wage growth: Despite the weak recovery, one seemingly bright spot in the post-GFC recovery has been the sustained improvement in employment. Across advanced economies, unemployment is now at or near pre-crisis levels (in some cases near NAIRU²). This would typically indicate a scarcity of workers, which should stoke wage and inflationary pressures (Chart 2)³. Yet despite low unemployment, wage growth remains subdued. Since 2008, average nominal wages in the G7 have risen by just 1.5% p.a., compared with 2.9% p.a. in the preceding cycle (i.e from 1991 to 2007).

  • Declining job security: Part of the reason for weak jobs growth is increased job insecurity. Despite the significant recovery in the number of jobs since the GFC, it appears that jobs quality has been deteriorating. Underemployed workers usually command less bargaining power, which is one explanation for anaemic wage growth and thus inflation since the crisis. The gap between actual and potential employment in advanced economies may be materially wider than headline unemployment figures suggest.
  • Globalisation and technological change: Labour market polarisation and the decline in full-time work are connected to the continued impact of globalisation and the disruptive impact of technology on lower-skilled work. Globalisation and technological advances have encouraged the development of complex global supply chains, allowing companies to maximise cost efficiency regardless of location. This shifts the balance of bargaining power from labour to capital and keeps wage inflation low.

What more can central banks do? The prolonged slump in inflation has created a dilemma for central banks. Advanced economies appear to be in a “liquidity trap”, where loose monetary policy simply generates asset price inflation (including real estate) but has little tangible impact on consumer inflation and the real economy. The next major step for central banks mooted by some commentators, is a “helicopter money” approach, which entails the central bank bypassing the banking system and directly funding new spending in the economy. This is a drastic and potentially risky step that could have unintended consequences (e.g. a loss of monetary credibility).

Total returns to remain low. While the jury is still out on whether the slowdown in inflation is dead or hibernating, in the absence of more drastic monetary action, the structural headwinds constraining inflation are likely to persist. We expect that the level of inflation is likely to continue averaging between 1% and 2% for some time to come while central banks maintain record low rates.

This will have significant implications for real estate returns. Inflation drives real estate returns through its impact on rents and yields. The initial impact of low inflation is to boost total return through yield shift; we estimate that yield compression has contributed around 2.3% pts of the 8.1% p.a. real estate total return in G7 markets since the crisis. But with interest rates near zero in most advanced economies, property yields are unlikely to come in much more. Assuming no additional inward yield shift and a 5.0% income return, total returns in a low inflation environment could be around 5.5% going forward (Chart 3), or a full 200 bps lower than the historic average.

1. It also depends on the central bank’s ability to successfully implement that policy.
2. NAIRU stands for the “Non-Accelerating Inflation Rate of Unemployment”. 
3. We proxy long-run wage growth with unit labour cost growth; this is wage growth above increases in labour productivity.

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