Deflated any longer?

Richard Dingwall-Smith asks if bond investors should worry that central banks are taking risks with inflation.

The global economy has weakened very sharply over the last six months. Few countries have been spared as the downturn has been transmitted around the world by the collapse of global trade and by the much reduced flow of capital and lending across borders. It now looks likely that global output will contract in 2009 for the first time in sixty years.

All else being equal, these developments would put additional downward pressure on inflation. An increased margin of spare resources produces a squeeze on profit margins in the near term. It may also depress pay and other costs, leading to continuing downward momentum in prices.

Of course all else is not equal, given the major response from governments and central banks. On the fiscal side, an easing equivalent to about three per cent of global GDP has been put in place (albeit spread over more than one year). Further fiscal action looks likely, as governments try to offset the retrenchment going on in the private sector. Moreover, governments are using substantial amounts of taxpayer funds to deal with the problems in the banking system, in an attempt to get credit flowing again.

However, the major issue for the inflation outlook is the impact of monetary stimulus in the form of extremely low interest rates and quantitative easing. In the US, the Federal Reserve has so far this year announced plans to buy $1,750 billion of Treasury securities, mortgage backed securities and agency debt from the private sector. This is equivalent to 12 per cent of GDP and is likely to lead to a surge in monetary assets held by the non-bank private sector.

Similarly in the UK, broad money may be directly boosted by about 7.5 per cent if the Bank of England undertakes the full £150 billion of asset purchases that the Chancellor has authorised. Switzerland and Japan have also seen some degree of quantitative easing; and the ECB may adopt similar measures.

Possible results
Will this inevitably feed through to inflation? In the short-term, the answer is no. The velocity of money may simply collapse, with money left sitting on deposit without much implication for spending or asset values. Indeed it is possible to imagine a situation in which output remains depressed, problems in the banking system persist and deflation develops despite the efforts of central banks – a classic liquidity trap.

However, a more probable outcome is that the global economy will gradually turn around, returning to positive but with muted growth by the end of 2009. This would reflect fiscal stimulus and an improvement of credit availability and confidence; and also an end to the inventory correction which has had a particularly severe effect in recent months. In response, monetary velocity is likely to pick up again, adding to the upward movement in real activity and also feeding through to inflation.

The issue then is how quickly central banks reverse the policies that they have put in place. For the moment the pressure on monetary authorities is to ‘do what it takes’ to get economies moving again; and they may be reluctant to change course until a recovery is unequivocally underway. And of course the lags from monetary policy to activity and inflation are notoriously long and variable. Clearly there is some risk that central banks could get it badly wrong.

The probability that inflation surges to levels not seen since the 1970s is probably no greater than the probability that the economy becomes mired in deflation. But there is a greater risk that central banks are implicitly ready to accept a period of above-target inflation – say five per cent for a couple of years – as a price worth paying to escape the current difficulties.

Such an outturn would be no great problem for equities. But government debt has once again become expensive. Investors have focussed on the short-term supply and demand implications of quantitative easing and have given little thought to what the position may look like a year or two ahead as economies begin to recover, inflation expectations move up and central banks start to unwind earlier asset purchases. In particular, US Treasuries with a ten year yield of about 2.7 per cent at the time of writing, and UK gilts at about 3.3 per cent offer poor value.

- Pensions Age April 2009