John Rapley is a political economist at the University of Cambridge and managing director of Seaford Macro.
This week’s U.S. and British inflation reports continued recent trends across Western countries, with inflation pulling back from recent highs. Next week’s Canadian figures will probably bring similar holiday cheer. Thrilled that central banks appear to be winning the war on inflation, investors have started their celebrations early, launching year-end rallies in stock markets and driving bond rates down.
But while the news is unquestionably good, those celebrations may be premature. There’s a sting coming in inflation’s tail, and you can spot it in the bowels of the figures.
The low prices of the past 30 years were effectively achieved on the backs of globalization and an increase of cheap labour. Now that both trends are reversing, we’ll never get back to the low inflation of the past no matter how hard we try.
Headline inflation was always going to fall, since the factors causing it were temporary. The pandemic and its lockdowns snarled global supply chains, stopping shipping and closing factories, with the consequent shortages causing prices to spike. Once economies reopened, these disruptions were going to abate, with markets gradually finding their way back toward balance. That process is now well under way. As a result, inflation will steadily feel more bearable.
But it probably won’t reach 2 per cent, the Bank of Canada’s target rate. When you dig into the inflation numbers, what you find is that core inflation, which strips out the most volatile elements, such as food and energy, is also falling. But it’s doing so much more slowly than the headline figure. Understanding why reveals an Achilles heel of economic theory.
Like most economists, central banks put their faith in the neoclassical model of inflation. This focuses on money supply and how it affects demand, the basic idea being that too much money chasing too few goods and services drives up prices. When that happens, the solution is to cut money supply. By raising interest rates, central banks can suck money from the economy, since people borrow and spend less and sock any extra they have into their savings accounts. With such ostensibly scientific management of the economy, believe the monetarists, central banks can engineer endless stability, a conviction enshrined in Milton Friedman’s oft-quoted adage that “inflation is always and everywhere a monetary phenomenon.”
Tiff Macklem says Bank of Canada remains concerned about inflation even as rate cycle nears end
So far, so good. The model has worked well for years. However, its laser-like focus on money supply has drawn everyone’s attention away from some of the other stuff going on. In a recent study with some colleagues, I plotted core inflation over the past 40 years against a measure of worker power based on the wage-profit ratio – the weaker the bargaining power of workers, the more managers can beat down wages and boost profits. What we found is an almost perfect overlap of the two. After about 1990, as workers’ power fell, wages went down and company profits went up, inflation trended steadily downward.
This was, of course, the era of globalization. The opening up of hitherto-closed economies, such as China and India, and a massive rural-to-urban migration across much of the developing world added some two billion people to the global labour supply in just a few decades. Advances in communications and transportation technology, and the liberalization of currency markets, then made it easier for Western firms to reach those workers via offshoring. In fact, firms didn’t even need to shift production abroad to beat down wages at home. The mere possibility of doing so restrained the demands of workers and weakened unions.
In short, weak workers made for weak inflation. But there was also something else our graph uncovered. In the past decade, the downward-sloping curve of workers’ power bottomed out. Due to changing demographic and migration patterns, the growth in the world’s labour supply has apparently peaked. The pandemic has further exacerbated the resulting tightness, with labour markets fragmenting as China and India turn inward and supply chains are “deglobalized” in favour of such things as “friend-shoring” – limiting trade relationships to like-minded countries.
Taken all together, these developments have limited the labour pool available to Western firms. That, in turn, has raised the bargaining power of workers. That’s why, despite slowing economies, employment is holding up and wages are still rising in most Western countries. Yes, they lag inflation. But because these trends look set to continue, there’s a good chance real wages will turn positive as early as next year.
Low inflation was an easy win for central bankers in the days when workers couldn’t demand much. So when the Bank of Canada flooded the economy with money, instead of raising prices in supermarkets, it filled the pockets of asset holders, with house prices and corporate profits rocketing even though the economy was weak. But as workers start to seize a bigger share of the pie, either profits will fall – bringing stock markets down with them – or inflation will persist, as employers make up their rising labour costs. In practice, it will probably be a combination of the two. That means inflation will eventually settle at a level that, while manageable for most people, is nonetheless higher than the target rates of central banks.
Trying to wrestle inflation all the way back down to 2 per cent would be wrong. Workers have borne the brunt of cheap prices for too long. More importantly, it would be futile. The changes occurring in world labour markets lie beyond the control of any central bank or government, and monetary policy can’t affect that. Instead, economists need to wrap their minds around the new economy taking shape and search for ways to exploit the opportunities it presents. There will be many.
In the meantime, don’t be surprised if 2023 turns out to be the year the Bank of Canada abandons its 2-per-cent target. It was originally set back in the nineties, when the globalization of labour markets was in full swing. But our world has changed, and while the bank may not say it openly, it’s a good bet it will have to abandon that holy grail.