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What could possibly go wrong?

As the recovery enters its ninth year, inflation remains largely dormant. It nevertheless needs to be watched closely.

2017 has been another year of strong and surprisingly widespread economic growth. Unusually, all major and most minor economies are currently growing. For the Eurozone in particular, we were able to continuously upgrade our forecasts – the latest one largely reflects revisions in the official growth estimates for earlier quarters. Growth in Japan has accelerated. In the United States, it continues to look well supported. China, that other source of perennial growth, is proving, well, perennial.

How long can the good times last? Throughout the year gone by, we have written extensively about political and geopolitical risks. As we look ahead, I would like to focus on a perhaps less obvious conundrum underpinning the current cycle. Inflation has remained surprisingly dormant across much of the developed world and the United States in particular. This is all the more remarkable, given the continuing strength of the U.S. labor market. If you take an average of the last six months, seasonally adjusted unemployment is at 4.3%, below levels last seen in 2007. Usually, you would expect wages to have risen well before this point. Rising wages should in turn have forced companies to raise their prices – contributing to further wage growth.

One increasingly popular interpretation is that the link between inflation and unemployment, depicted by the Phillips curve, is permanently broken. Three reasons are frequently advanced: demographics, technological change and globalization. None of them is quite convincing, least of all in terms of the timing of the most recent Phillips curve flattening. For example, it is commonly thought that an older population puts downside pressure on inflation, as the elderly tend to spend less. However, older people also tend to demand more labor-intensive services, such as health and home care, which is likely to lead to upward wage pressure in these areas. Indeed, a recent empirical study of our colleagues at DB Research showed that in the United States, regions with a higher percentage of older people tended to see more, rather than less inflation. Decomposing the labor force into age groups also reveals that the slow growth in aggregate measures of average compensation is partly due to higher-wage baby boomers retiring. If you look only at hourly earnings of U.S. workers aged 25-54, the Phillips curve appears very much alive.

Similarly, it is often argued that the massive investment in technology will continue to be deflationary. Intuitively, that too makes sense. For example, more and more of retail revenues is moving online. This allows consumers to compare prices with the speed of a mouse click, perhaps limiting the scope for price increases in any goods sold both online and in stores. Once again, however, there is no reason to think that this will necessarily always be so. At some point, online retailers might be sufficiently dominant to start pushing up prices. Finally, global competition might at times keep a lid on wages and prices, but there is no reason to think that this should be a one-way street. Just because globalization has contributed to moderate inflation in the past does not mean it always will. Not so long ago, some of the same people now doubting the link between inflation and unemployment were similarly unconvinced that currency devaluation would trigger inflation. Since then, inflation in the United Kingdom following the Brexit referendum and the fall in the pound has proven the old economic textbooks right.

All this underscores that you would need to investigate why and how exactly causal links might be changing, rather than dismissing familiar economic reasoning altogether. Our upbeat base case rests on the notion of inflation inertia, the idea that low inflation in the recent past tends to cause low wage demands. Adjustment to better economic surroundings and thus higher inflation takes time. A key risk to this is that we could see a sudden upward reversal in inflation once unemployment falls too much, forcing central banks to tighten policy very quickly. It is equally possible that disinflationary pressures of the sort we described above might prove stronger for longer. Either way, "low and slow" does not equal "never ever," whether you are talking about inflation or tightening monetary policy.

A flattening Phillips curve?

The Phillips curve measures the supposed trade-off between cyclical unemployment and inflation. In recent years, it appears to have gotten flatter.

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH as of 11/9/17

* Private sector

A Brexit-induced inflation shock

Following the Brexit referendum, the pound sharply devalued, resulting in higher prices for imported goods and also higher headline inflation.

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH as of 11/9/17

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