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On Thursday, January 7, Charles Goodhart joined Markus’ Academy for a lecture on inflation and interest rates.

Goodhart is a Professor at the London School of Economics

Watch the full presentation below and download the slides here. You can also watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

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Executive Summary

Looking at the last three centuries, interest rates were steady up to 1950, after which it increased drastically up to 1980. This suggests that inflation expectations were steady before yields and expectations rose dramatically, due to the Keynesian economics driven policies.

1980s to present inflation rates and expectations going to historically low levels, due to globalization and demographic changes. Eastern Europe and China’s working age population (WAP) became included in the world’s trading organization, which doubled the world wide labor force. Employers went from high skill to low skill production, and with relative prices held down, there were credible threats to producers to keep wages down. Shifts in demography after the WW2 baby boom led to a lull in the proportion of young in the economy. Now, the ratio of working age is relatively steady, with the exception of Japan with a massive increase in retirees.

Shift of production from high wage to low wage has improved world equality but increased within-country inequality. World inequality increased from the 1800s to 1980, when America and Europe bounded ahead with the industrial revolution but Asia remained behind. Starting from 1980, Northern Asia has begun to catch up: the ratio of average wage in the US to China has decreased from 35:1 to 5:1. However, this led to increased competition for low wage workers in a high wage economy, leading to more inequality within countries.

Increased number of elderly has led to sharp rises in expectations for deficits and debt, even before the pandemic. With the pandemic, this expectation has been exacerbated and increased.

Growth and government policies are unlikely to decrease deficits — the politically easier to implement solution will likely be inflation. Growth is an unlikely fix because the number of workers will grow slower in the future than it has in the past, which requires a dramatic increase in productivity to offset. The government is also unlikely to increase taxes and reduce expenditures due to political reasons. Therefore, the most politically likely result is inflation, which will be necessary to bring down the current deficit amount. Inflation will pick up a year after the pandemic has been alleviated with vaccinations and the economy opens up. The pandemic has led to huge monetary aggregates, leading the private sector to increase markups to pay back its debts. This will expedite the shift from low inflation to high.

Africa and India have a significant period of growth ahead of them. This is unlikely to lead to tailwinds globally, though, because there is a relative lack of coordinated policies that occurred during China’s growth in both the African countries and India. Due to such administrative problems, it would not be most productive to just provide them with capital.

In summary, inflation will occur due to increased stimulus to households, the yield curve will steepen, asset returns will be harder to extract, within-country inequality will lower, and central bank independence will come under increasing threat.