Inflation: The monetary whirlpool

Will central banks be able to keep the opposing currents of inflation and deflation in check, or will inflation take us down the drain?
Inflation - The short term outlook is more optimistic than you might think./ Credits: Shutterstock
When countries started to flood the markets with stimulus packages and easy money following the 2008 financial crisis, experts warned of an inflationary, if not hyperinflationary, effect.

What they may have failed to take into account, however, was how extreme the global contraction had been and how difficult it would be to counter its massive deflationary pull. In fact, at 5.6% (CPI) in July 2008, the US inflation rate shortly before the financial crisis was the highest it had been since 1990. By December 2008, it was 0.1% and continued to drop until July 2009 (-2.1%).

Economic theory has it that inflation is the consequence of money supply expanding faster than production. As consumer demand increases, so do prices. The opposite is true of deflation, when money becomes short and production curtailed. Prices may go down, but as companies look to trim their budgets, so does employment.

While differing in absolute terms, inflation shows a similar picture over recent years across both emerging economies and the Eurozone. Hovering between 1-9% and 4-11% in China and India respectively and 1-4% in the Eurozone prior to the 2008 crisis, the inflationary curve in these markets exhibited the same sharp drop and return to previous levels as the United States experienced after the financial crisis. Since then, inflation stabilised slightly below 2%.
José Marin Arcas, head of Euro Area Macroeconomic Developments at the European Central Bank, cites the drop in food and energy prices as key reasons for the following rebound. “Rising commodity prices such as oil tend to affect consumer price indices directly by raising their energy cost component,” he explains.

On 12 September 2008, two days before Lehmann Brothers went bankrupt, the price of crude oil was $101.19 (WTI). By 22 December, the price had fallen 70% to $31.10 and remained below $50 until 24 February 2009. As the price of crude oil began to increase over the spring and early summer, inflation began to follow suit. Looking forward, Marin Arcas says, “While we had wild fluctuations in oil and non-energy commodity prices up until 2011, we expect greater stability in the short term and, for the medium to long term, we expect to see 1.5 to 1.8% inflation (HICP) in the Eurozone.”
Inflation rates over the past two years have been higher than would have been expected given the output gap. Even so, long-term inflation expectations have remained very well anchored and, according to the EMU Survey of Professional Forecasters (SPF), the inflation expectation in the Eurozone for the next 2-5 years is at 2%.

Stefan Hofrichter, chief economist at Allianz Global Investors, advises taking a global view as major swings in inflation and disinflation came to be global phenomena in the past. “The global monetary expansion rate is roughly 7%, about the same as nominal growth worldwide, which is not excessive. If you use the argument that too much liquidity leads to inflation, then there is no inflationary nor deflationary pressure, at least not for the next two years.”
Yet, inflation may still be lurking in the shadows. One reason for concern could be central banks’ ongoing expansionary policies as they focus on financial stability, partly due to increasing political pressure, Hofrichter warns. Market participants might conclude that central banks are willing to accept higher inflation rates.

Rob Parenteau of the consulting firm MacroStrategy Edge points to two possible scenarios: one is a currency depreciation, which could trigger a competitive depreciation cycle, rising import prices and inflation. For instance, the Bank of Japan recently announced it would be buying government bonds as a means of injecting additional money into the economy, thereby adopting an inflationary policy. While most central banks worry about keeping a handle on inflation, Japan’s economy has been battling deflation for almost two decades.

“Another possible route to inflation is that, if successful, central banks’ efforts to increase asset prices could lead to more spending both in the private and corporate sector,” says Parenteau.

So while the consensus is that inflation is hardly a risk in the short-term, the global economy’s fine balance is easy to upset.

Read more on investment strategies on Project M online.

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