Shocks that will reshape our economy

Michael Hughes on crucial changes behind the inflation figures

Inflation is a major determinant of financial market behaviour. Unexpectedly high inflation raised long bond yields in the 1970s and lowered equity prices. Negative inflation can raise the real value of debt and lead to a deterioration in creditworthiness, and hence can also be bad news for bonds and equities. Appreciating the inflation environment is a key feature therefore of investment planning.

However, inflation is treated by economists very differently from economic growth. When we examine economic growth we tend to investigate the individual components of GDP. High growth coming from personal consumption is regarded as less satisfactory than if it emanated from an improved export performance. Inflation statistics, by contrast, tend to be taken at face value.

However, an inflation rate that represents the profit share of GDP rising is preferable to one which represents costs being passed on. Equally a low inflation rate that comes from an increase in aggregate supply is preferable to one which is the result of weak demand. Understanding the background factors determining inflation is more important for long-term investment planning than simply reacting to the headline figure.

One of the problems with analysing the global economy at present is the confusion over whether deflationary forces are responsible for low inflation. How can we distinguish between low inflation due to weak demand and one due to increased supply? At present, both forces are at work. The table below provides a rough guide to indicators of each phenomenon.

Technological advances and increased competition have led to reduced telephone charges and electronic chip prices. Additional capacity in many manufacturing sectors, particularly in Asia, have reduced manufactured goods price inflation to less than 1 per cent a year.

Increased productivity within the OECD area has also contributed to this increase in aggregate supply. The weak demand profile is illustrated by negative commodity price inflation, reduced real bond yields, and weak freight rates.

Tempting though it may be to apply the deflation theory to Asian economies and reserve the supply shock thesis to Western industrial nations, the more realistic observation is that all these factors represent global, not just national phenomena. The investment judgement that needs to be taken for longer-term planning is: which force will dominate.

Our judgement is that the supply shocks of recent years will exert the greater influence on economies over the longer term, hence our comments here are concerned with these global developments rather than Asian deflationary effects that have already been covered extensively in the press.

The global economy has experienced a whole series of supply shocks within a short period of time. So far in this decade we have experienced five shocks: 1) the end of the Cold War; 2) the globalisation of companies and capital; 3) technological revolution that has taken the marginal cost of communication towards zero; 4) deregulation of businesses to encourage greater entrepreneurship; 5) the growth of the information or knowledge- based economy.

All five influences are difficult to quantify but we can draw on some evidence to illustrate the first three. The demise of Communism and ending of the Cold War has facilitated a reduction in defence spending and hence a shift in resource allocation to more productive areas. Back in 1989- 90 total defence spending accounted for 3.7 per cent of GDP for the OECD region as a whole but 5.7 per cent in the US alone. These figures have reduced to 3.6 per cent for the US and around 2.25 per cent for the OECD as a whole. Therefore some 1.5 per cent of GDP has been released to support spending in areas which have a higher multiplier effect on the economy.

The impact of globalisation is difficult to quantify. Various proxy measures have to be employed. For example, the aggregated current account surpluses of 12 large economies reveal an upward trend for capital mobility since the 1960s. Interestingly, this has yet to reach the levels of a century ago although it seems probable this upward trend will be maintained as the segmentation of world financial markets decreases.

Another measure of globalisation is the build-up of international capital flows, particularly for direct investment. The surge in direct investment during the latter half of the 1980s was unprecedented in both size and diversity. By the end of that decade multinational companies from G5 economies owned over $1b of direct investment assets abroad. Some 70 per cent of this total was acquired during the 1980s. The pace of acquisition has accelerated in recent years, having slowed down during the early 1990s.

A final illustration of the impact of globalisation is the rising share of global production in world output. Recent estimates of the value-added output of multinational affiliates abroad (this excludes the output of parent firms in their home countries) as a share of world GDP show a rise of 2 percentage points over 20 years to reach 6.4 per cent in 1990. An acceleration during this decade produced a 7.5 per cent share by 1995.

Technical change is also a difficult concept to measure and most macro- economic models regard this as a "residual" item. It may be more relevant therefore to examine some of the micro evidence.

The rate of technological change has been accelerating over the years but more relevantly for our current thesis, the rate at which products come to market and are accepted by large portions of the market has also accelerated.

Computers are getting more user-friendly, contain more memory and are getting cheaper. Within the next decade integration between speech and text should be possible; the storage capacity of chips will increase to approximately 100 megabytes, which represents the storage capacity of 50,000 typed sheets of A4. The development that could make most impact is the use of information technology not just to process data, as in the past, but to move it from one place to another.

All this will be achieved at lower prices. By the end of this decade the price of computer systems will be only 1 per cent of the price of a standard unit of power in 1960. In essence the price of computer power has decreased by a factor of 10 every 10 years. The price of storage is declining at the same rate.

Taking all five factors together, it is likely that there has been a shift in the supply side of the global economy which may end up being very significant. But how significant?

We have attempted to answer this question by calculating the past relationship between output gaps for the G7 as a whole and inflation. The difference between current inflation and what would have been expected from the past relationship between output gaps and inflation provides a rough guide to the effect aggregate supply changes have had. The answer is surprisingly small, around 0.5 per cent a year.

However, the full impact of these supply changes have yet to be felt and hence the final figure could be higher. This is before additional supply-side surprises such as the impact of price transparency in the European single market take effect. These surprises help to explain the apparent decoupling of economic growth and inflation in major economies, notably the US, in recent years. Investors can take comfort from the fact that if they remain dominant the long-term bull market in equities and bonds has much further to run.

Michael Hughes is group economic adviser at Barclays Capital.

Global inflation

Determined by increased supply

Computer chip prices* -50.0%

Telecom prices* -12.0%

Manufactured goods price* 0.6%

Determined by reduced demand

CRB Commodity Index* -7.0%

Real bond yields** -0.5%

Freight rates* -19.1%

* Year on year % change

** Change in rate from year earlier

OECD export prices of manufactured goods

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