Today, the European Central Bank (ECB) President, Mario Draghi, made an interesting comment. The amount of times that happens can be judged by the fact that when you enter “Mario” into Google, the suggestions include a lot of “Super Mario Brothers” themed searches along with several other Marios, but you have to get as far as “Dr” in his surname to elicit a Draghi suggestion.
That lack of newsworthy or interesting comments is no accident.
For a central banker, and particularly one tasked with overseeing the (often conflicting) economies of a large group of diverse nations, “interesting” is not usually a good thing. In this case, however, Draghi talked of the possibility of slower than expected inflation, and that should be interesting to us all. It is something that U.S. economists are starting to ponder as well, and it is taking on the form of a mystery. The conditions for inflation seem to be all in place, but we aren’t seeing any.
That raises two questions for U.S. investors: why not, and how will it affect me?
From 2008 through late in 2014, the Fed was engaged in one of the most ambitious monetary policy experiments ever. QE was a desperate response to desperate times, and involved the central bank effectively creating as much as $85 billion a month and handing it to banks while simultaneously holding down interest rates.
That was incredibly controversial at the time, with the main criticism coming from fiscal conservatives on the political right (remember them?) who claimed that it was a recipe for raging inflation further down the line. That was an argument that was supported by economic theory but has so far proven to be inaccurate.
The theory is that all that monetary stimulus and ultra-low interest rates would give a quick, manufactured boost to economic activity, but we all know that printing money is a bad idea, right? Anybody who has studied economics has heard tales of Weimar Republic Germans taking their wages home in wheelbarrows, and that looked on the cards for Americans once the job market recovered while all that cash was still washing around the economy.
Yet, with “full employment” reached a while ago, core inflation remains at around 2%.
The first and most obvious reason for that is that the recession was deeper and longer-lasting than we thought. That is no doubt true, and certainly explains why wages failed to rise as unemployment fell. There were lots of people that wanted to work but were so discouraged that they had dropped off the rolls of the officially unemployed and, when conditions began to improve, they rejoined the labor force. Even so, wages have been improving for a while and all that cash is still out there, but prices are relatively stable.
Something is obviously different this time, or more accurately a couple of things. First there is the effect of the internet and smartphones. It is hard for prices to be increased when we all can just reach in our pockets and find the product cheaper elsewhere. That creates greater efficiency for consumers, which is a good thing over the long term, but it makes prices extremely sticky.
On a larger scale, the same “problem” of market efficiency exists at a global level. Low manufacturing costs overseas and intense competition also keep prices low.
Still, the pressure that would normally push prices up has to be let off somewhere, and in his speech, Draghi hinted at where that was. He used the phrase “squeeze on margins” to describe why inflation could stay low. To most stock investors that probably sounds like a bad thing, but in the long term it is better than the alternative.
We are talking here about a big increase in the cash in circulation, and therefore in demand for goods and services, but circumstances that don’t allow firms to respond to that higher demand by increasing prices. Margins get squeezed, but revenues grow, so the net effect on profits could still be positive. That may come as a shock to corporations used to enormous pricing power both in terms of labor and their finished product, but it could allow for higher wages, decent growth, and low inflation, the trifecta of a strong economy.
More immediately for stock investors, if the above assessment is right, most of the fears that are driving this big drop in stocks will prove to be unfounded. The Fed won’t be forced into more draconian rate hikes, nor will overall growth necessarily slow. The lack of inflation therefore, may be a mystery, but it is likely to be a mystery with a happy ending for investors.