Global reflation to triumph over deflation
The threat of deflation that has loomed large over the global economy in recent years is finally starting to lift as the US recovery and accommodative monetary and fiscal policies take effect, writes Michael Grady
In recent years global goods and services inflation has been both well below the rates of increase seen in the years before the 2008/09 financial crisis, and the rate targeted by central banks. Indeed, in many developed economies prices have been falling modestly for much of the past 18 months. Persistently low or falling inflation has led many to predict that, just as Japan found after the financial crisis there in the early 1990s, the major developed economies will be unable to generate the necessary growth to reflate their economies. We think those predictions are too pessimistic. We expect that global reflation will ultimately triumph over deflation, with the United States leading the charge. That said, risks such as geopolitics, a lack of appetite from businesses to invest and the potential for China to slow more sharply could undermine recovery.
Past disinflation due to deficient demand
There have been two key drivers of the disinflationary environment of recent years. First, the fallout from the global financial crisis, followed by the sovereign debt crisis in the euro area, left many economies with a large shortfall between aggregate demand relative to potential supply. Commonly referred to as the ‘output gap’, this shortfall in demand was a reflection of the sharp decline in output and increase in unemployment. The global recession of 2008/09 was the largest since the Great Depression of the 1930s. Absent any policy response, it likely would have sent the world into a deflationary spiral. However, aggressive easing actions from central banks limited the extent of both the economic downturn and the disinflationary consequences.
Despite the extended period of extraordinary monetary policy accommodation, the recovery in global growth over the past few years has been disappointingly slow compared to previous recoveries. That likely reflects a range of factors, including persistent headwinds from the financial crisis restraining investment, a slow down in labour productivity growth and the debt overhang in emerging market economies curbing their rate of growth. The slow pace of recovery, combined with the limited rise in wage growth during that recovery, has meant that underlying inflationary pressures have remained muted. However, there is evidence that these pressures are starting to rise, particularly in the United States where the recovery is most advanced.
Oil prices effects significant but temporary
Alongside muted underlying inflationary pressure, in late 2014 oil prices fell sharply from around US$100 a barrel to a low of around US$30 a barrel in early 2016. Other commodity prices, such as metals, also fell. As important inputs into production (and in the case of oil, an end product in the form of petroleum), the decline in commodity prices put further downward pressure on goods and services inflation. Headline CPI inflation is currently around one percentage point lower than core (which removes the direct impact of energy and food price inflation) across the major economies. At its peak, the impact on US headline inflation had been nearly twice that.
Much has been written on the main drivers of lower oil prices. We think that the bulk of the decline can be explained by an unexpected increase in current and future supply. Absent a negative demand shock, with oil prices now much closer to their marginal cost of production for many producers, we think that there is limited further downside for prices. Futures markets currently imply little change in oil prices over the coming year. If that proves to be correct, then the drag from oil prices on headline inflation will dissipate. That would eliminate the one percentage point gap between headline and core inflation.
Extended easy policy to boost inflation
Over the course of 2016, with the exception of the US Federal Reserve (Fed), all the major central banks around the world have eased policy again. In the euro area, concerns that persistently low inflation could push expectations of future inflation unacceptably low was the catalyst for further expansion of quantitative easing (QE), including the purchase of corporate bonds. Following the vote for the UK to leave the EU, the Bank of England similarly undertook a range of easing measures (including lowering interest rates and re-starting QE). Meanwhile, Japan has continued to pursue aggressive monetary easing. While the Fed has not eased policy this year, expectations of tightening at the start of the year have been pushed further out.
The case for easier policy in the euro area, UK and Japan is not difficult to make. Each is dealing with slightly different issues, but ultimately all need to generate more underlying inflation. The US is slightly different. Core inflation there is already close to target and the domestic economy is performing solidly. However, the Fed has decided to pursue a risk-management approach to policy that aims to cement the economic recovery and generate a sustainable return of inflation to target. That approach is likely to see inflation overshoot target for a period of time. It is an approach that we expect to see employed by other central banks in future.
In addition to an extended period of easy monetary policy, we see an increased likelihood of fiscal policy being used as a tool to boost investment and growth. The IMF’s latest World Economic Outlook called for a three-pronged approach to securing higher and sustainable growth: structural reforms, monetary accommodation and fiscal support. Japan and Canada have recently announced large fiscal stimulus packages and China has also undertaken a fiscal expansion this year. In addition both the US presidential contenders are campaigning on fiscal expansion. Increased use of fiscal policy will also help to reflate the global economy.
If reflation is to triumph over deflation over the next couple of years, there are likely to be significant implications for global markets. US equity markets have reached new highs in 2016. By itself, that might suggest that market participants are increasingly expecting a reflationary outcome. However, that has happened at the same time as the yield on long-dated US treasuries has fallen to new lows. Part of the explanation for the low level of US yields has been a decline in market-based measures of inflation compensation (often referred to as breakeven inflation). We think there is an opportunity to position for a move higher in market breakeven inflation rates, which should start to reflect higher inflation outturns. For that reason, and given generally stretched valuations, we think investors need to be cautious around longer-dated government bonds. As the euro area and Japan pursue aggressive reflationary policies, we also expect equities to perform positively in those markets. Furthermore, any reallocation out of bonds on fears of inflation rising faster than expected, is likely to intensify the hunt for yield in riskier asset classes.
 See Kindberg-Hanlon and Middledrop (2015), Bank of England for one approach to decomposing energy price moves into supply and demand factors (https://bankunderground.co.uk/2015/06/26/oil-is-not-as-it-seems-expectations-of-future-oil-supply-key-to-explaining-drop-in-price/)
All Macrobond data as 31st July 2016
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