Why inflation is still so low

Moore’s Law and the technology factor

When 2017 began, many economists in the U.S. expected inflation to accelerate. The labour market was tightening, and unemployment was low. But core inflation, which excludes volatile food and energy prices, registered just 1.9% year-over-year that April, down from 2.3% that January. Prices actually fell in March 2017, the first time U.S. consumer prices had dropped month-over-month since January 2010.

The situation then was unusual, but now, two years later, it’s increasingly clear that inflation remains tame – significantly below the 2% annual target set by the makers of monetary policy in many developed nations.

Why is this happening, when the U.S. job market remains tight? And what does it mean for investors? To answer the first question, look no further than Moore’s Law, which explains how ever-cheaper and ever-better technology reverberates through the U.S. economy.

A closer look at Moore’s Law

Moore’s Law states that as technology improves, its relative price declines. The wholesale price of cell phones, for example, fell 13% in the United States in April 2017 from a year earlier. But Moore’s Law (coined by Intel co-founder Gordon Moore) is about more than tech products. Its indirect effects restrain prices in every corner of the economy.

According to the U.S. Bureau of Economic Analysis, the amount of technology used in producing goods and services more than doubled from 1997 to 2017, from 8 cents per $1 of output to 17 cents. The impact has been most pronounced in tech-intensive industries such as information technology and communications, professional services, and manufacturing. But as the graph below shows, even sectors that may seem less directly tied to technology – such as health care, education, and retail trade – have seen significant cost savings.

Our research suggests that declining input prices for computers and electronic products, computer design and services, and other technology inputs trimmed almost 0.5 percentage point per year from production costs from 2001 through 2017 and ultimately from wholesale prices. Without Moore’s Law, annualized U.S. inflation would have been almost 0.5 percentage point higher. Without technology’s price-suppressing effects, core inflation would be at 2% or more, achieving the Federal Reserve’s inflation target. The higher inflation that would have resulted would have forced the Fed to further raise interest rates.

Implications of low inflation for investors

Vanguard expects the U.S. inflation rate to remain subdued over the next 10 years, with core inflation hovering around the Federal Reserve’s 2% target. Modest inflation should help boost economic growth, as interest rates are likely to remain low.

And technology’s role in dampening the effects of inflation should be mostly good news for bond investors, particularly retirees and others with relatively shorter time horizons. That’s because lower inflation preserves the value of a bond’s coupon payments, which remain fixed until the bond matures.

Low inflation should also support stocks, as lower input prices strengthen corporate profits. Persistently low inflation also restrains yields and makes less risky investments, such as money market funds, less attractive.

There is always a chance that materially stronger global growth, accommodative monetary policy, or economic shocks such as an all-out trade war could spur higher-than-expected inflation in the coming years. But we expect Moore’s Law and the pace of technology innovation to remain an obstacle to central bankers’ 2% goal.

Joseph H. Davis, PhD, is a Vanguard principal and the global head of The Vanguard Group, Inc.’s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics. As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group, which oversees more than US$700 billion in assets under management.

Notes and Disclaimer

© 2019 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.

Important information

The views expressed in this material are based on the author’s assessment, are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise. Any “forward-looking” information contained in this material should be construed as general investment or market information and no representation is being made that any investor will, or is likely to achieve, returns similar to those mentioned in this material or anticipated in this material.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

Information, figures and charts are summarized for illustrative purposes only and are subject to change without notice. In this material, references to “Vanguard” are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.