Inflation: down, but not out

Madhur Jha Head, Thematic Research

13 Oct 2015

How worried should we be about deflation? Time to get the pressure on prices into perspective

Investors are obsessing once again about deflation risks in the West, spooked by a collapse in commodity prices and slowing growth in emerging markets, particularly China.

Six years after the global financial crisis, the world economy is stuck in a ‘lowflation’ environment, with inflation below the common target of 2 per cent, and we expect this to prevail in the next two years.

Looking five years out, however, we believe it is most likely that inflation will move back towards target.

We believe that demand from burgeoning middle classes in emerging markets will boost consumption and investment

In this, we’re not as pessimistic as some, who fear that demand will stay chronically weak, keeping inflation very low, or forcing it below zero.

We believe that demand from burgeoning middle classes in emerging markets will boost consumption and investment. The OECD expects the combined purchasing power of the middle classes globally to double by 2030 to USD56 trillion, with more than 80 per cent of this demand coming from Asia.

Easing of headwinds

This expansion should support global demand, alleviating concern about ‘secular stagnation’ – very low or no economic growth.

We see a general easing of the headwinds that have been driving inflation lower, such as fiscal tightening and deleveraging. We also think that fear of derailing economic recovery – and the desire to avoid deflation – makes central banks more likely to err on the dovish side, potentially allowing higher inflation.

The biggest risk is a new recession in the next few years

Whether we’re right will hinge upon the extent to which investment picks up, the pace of China’s slowdown, the response of wages to low unemployment, and whether productivity growth recovers. All these are factors that we will be keeping a close eye on.

The biggest risk is a new recession in the next few years. To avoid this, we believe central banks need to keep policy accommodative. A new global downturn this soon would push inflation lower, and, starting from a very low level, threaten a slide into deflation.

Above all it’s this fear of another downturn – and the knowledge that there is very limited scope for new fiscal or monetary manoeuvres to counter it – that we think will make central bankers cautious about tightening monetary policy.

Inflation targeting here to stay

The US Federal Reserve, European Central Bank and the Bank of England have done a reasonable job at keeping inflation close to 2 per cent since the 1990s. But there is criticism that they have focused on inflation at the expense of ensuring financial stability, with some now calling for the inflation-targeting regime to come to an end.

We think central banks will eventually conclude that the costs of moving away from inflation targeting are higher than the benefits.

Meanwhile, with ‘lowflation’ a reality for the foreseeable future, expect deflation fears to continue to make the headlines for a while yet.

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