The Return of Disinflation

Carraighill has examined the disinflation forces that have dominated the Euro Area, the US, Japan, China, and the UK since the late 1970’sThe ultimate purpose of our work is to better understand the evolution of interest rates as this has implications for the outlook across multiple financial service sectors, including banking sector returns, asset management, payments, and property.  

Despite the recent narrative of inflation, we believe the balance of forces continues to weigh in favor of disinflation over inflation. This is due to weak demographics and the high levels of debt which continue to lower the marginal productivity of new credit. 

Inflation forces act in a finely balanced “tug of war”. To follow the analogy, these forces have gained ground in recent months, with high CPI readings in the US and rising inflation expectations elsewhere. What people miss is that the disinflation side is still pulling hard in the other direction. In the near term (1-2 years), this side should reassert itself and gain ground as supply issues resolve and labour markets return to normal following the pandemic.

This will most likely occur coincidently with sluggish GDP growth, continued central bank accommodation, rising asset valuations, and widening economic inequality. The political desire to rectify these trends will only grow.

The Disinflation Thesis

Our core thesis is that strong disinflation forces persist, which will lower long-term bond yields (even further) and pressure bank earnings over time.

Point 1: Economic growth is determined by four factors of production. These are land, labour, capital, and enterprise. Capital includes debt and equity.

Point 2: The overuse of any one factor lowers its marginal productivity. As debt rises, the additional GDP generated is lower. The tipping point seems to be close to 200% of GDP, but it varies by country. Above this level, for each additional unit of debt, the value generated falls in an accelerating non-linear fashion. The correlation is high, and we have already witnessed this in Japan and the Euro Area.

Point 3: As the marginal return on debt falls, the velocity of money falls

Point 4: Loan demand weakens progressively as debt rises. As velocity falls, interest rates and loan rates decline to try and stimulate further credit demand.

Point 5: Falling demand for private sector debt is replaced by government debt. Large fiscal deficits are politically palatable and encouraged by central banks, as the lack of credit creation slows economic growth. Central banks focus on trying to facilitate economic expansion by keeping rates low through QE.

Point 6: High debt lowers the inflation rate. While money supply and inflation are positively related, the relationship weakens in highly indebted economies. These economies are much more likely to experience disinflation. Much higher levels of money supply growth are needed to create inflation.

Point 7: After each crisis, there is an initial rebound in GDP, but this quickly fades. This was seen after the crises of 2001, 2008, and 2020. The fading of GDP growth coincided with the return of disinflation. Both are weighed down by the ever-higher levels of total economy debt taken on in response to each new crisis. Again, interest rates fall after an initial bounce, and the cycle restarts (at point number 2).

Point 8: The 2021 inflation is due to supply bottlenecks which should reduce in time.

Point 9: This should cause long-term interest rates to decline again. As disinflation re-emerges, long-term yields will again fall. Interest rates will fall, which will depress bank NII/asset ratios and share prices.

Supply and Demand Inflation Drivers

Historically, there have been numerous occasions when supply chain disruption or strong demand resulted in higher CPI. This includes the 1970s oil price shock, the period from 2000 until 2006, and immediately after the GFC in 2009. In most cases, banking equities initially performed well as bond yields rose and the yield curve became increasingly upward sloping. As we seek to assess today’s environment, we review both the supply and demand sides.

A prerequisite for higher inflation appears to be supply chain tightness. However, if the demand side is not strong, cost pressure will manifest in reduced corporate profit margins. The changing evolution of household spending is therefore important (some industries will benefit more than others).

We are currently in quadrant A (from a reported CPI and news-flow perspective). Our view is that we will transition to quadrant D over time with a return of disinflation. The issue, of course, is timing. This transition could be rapid given the pace at which new technologies are embedded into consumers’ habits (zoom, online shopping, etc.). It could also be slower for some sectors, such as shipping, where new ship orders take over a year to enter the system.

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