Why we need to be on alert for higher prices.

Money manager outlines case for inflation’s return

According to one Nobel laureate, inf l ation is “always and everywhere a monetary phenomenon.” But in a series of seminars conducted this week in Canada by New York- based money manager Alliance Bernstein, another set of factors explains why inflation is set to return over the next couple of years — all of which is expected to flow into higher interest rates.

Scott DiMaggio, the firm’s director of global fixed income, said while “the fake news” is that inflation is dead, we need to be on the alert for “higher prices.”

To support that thesis, DiMaggio posited five factors. The first is the rise of populism, a force he believes causes “structural inflation pressures.” To help with the analysis, DiMaggio presented three populism boxes: raising the drawbridge (which includes the mix of increased trade protection, capital and labour flow restrictions, and the withdrawal f rom supranational relationships); institutional erosion (which includes the winding down of monetary polic y i ndependence, a factor present in Japan, “where the central bank is being asked to fund the government’s fiscal expansion”); and redistribution (increased taxation and higher minimum wages). Combine them and what results is higher prices.

“In our estimation all three of these results of populism do lead to inflation,” noted DiMaggio.

Demographics is t he second factor pushing prices higher. DiMaggio presented a graph using British data showing the negative relationship between the change in working- age population ( the environment expected in the future) and the average inflation rate. “As countries age, inflation does tend to creep higher,” he said.

The debt overhang — the high rate of non- financial debt to GDP — is the third contributing factor. “Central banks and governments will want to generate higher inflation as the easiest way to deal with big debt burdens,” said DiMaggio.

The one positive to lower interest rates is continued quantitative easing, a process where key central banks expanded t heir balance sheets by purchasing assets from financial institutions.

While the U. S. Federal Reserve ended the policy in September, the European Central Bank and the Bank of Japan are pressing on. “We are not there yet. We are not done for at least for 12 months. QE is still going to exert a significant influence next year,” said DiMaggio who estimates U. S. 10- year rates are about 200 basis points below where they would have been were it not for QE by the three heavyweight central banks. ( For Canada, the QE effect is estimated to be about 60 basis points.)

But won’t technology’s ability to keep prices low — despite the US$ 1,000+ t ag f or t he recently released iPhone X — be able to counter the other factors pushing prices higher? In a word, no: the negative forces are stronger.

Given the dominant role the U. S. Federal Reserve plays in the world economy, DiMaggio said upcoming personnel changes in the wake of Jerome Powell being named the new chairman need to be watched carefully. “When you look behind the curtain there are a lot of new faces out there,” said DiMaggio, at both the FOMC ( Federal Open Market Committee) level and the 12 district banks.

“While you might think that monetary policy is on a set course, the ( slew of ) new faces, will lead to, potentially, a lot of instability,” he said. If there’s a crisis, it’s possible the response may be different from what occurred previously, given that Powell does not have the academic economic background of the two previous chairs, Ben Bernanke and Janet Yellin.

So what’s the appropriate bond investment strategy? One path, DiMaggio suggests, is a combination of inflation- linked bonds and an extension of duration.