Although inflation fears are currently high the real risk for the world economy is deflation.
Arguing that the world economy is facing major deflationary pressures might seem strange when inflation in many countries reached its highest level in nearly 20 years in June. And from a consumer point of view, there is no denying that the cost of living has risen given soaring food and energy prices.
The demand destruction resulting from the rise in food and energy prices is however precisely one of the reasons why fears of deflation may quickly reappear. If, as consumers, we have to pay more to fill up our car or to heat our house, we have less money left over for discretionary items, which ultimately leads to a fall in the prices of these items.
In my 6 March article I argued that there were major differences between today's environment and that of the 1970s which was characterised by structurally high inflation. One big difference is globalisation which means that (at least for now) we are in an environment of excess supply rather than excess demand (this is obviously not true for commodities where globalisation has led to an environment of excess demand). Another difference is that there is currently no pass-through of higher food and energy prices to other segments in the economy. For such a pass-through to take place, wages (or more precisely unit labour costs, i.e. wages adjusted for productivity gains) would have to increase. That's what happened in the 1970s when wages were indexed and unions much more powerful. There is currently no sign of that happening with unit labour costs remaining tame in both the G7 and the major developing countries. Incomes are falling in real terms making the increase in food and energy prices even more painful for the consumer.
For someone walking into a supermarket or stopping at a gas station, inflation is a reality and the above discussion may seem academic. However what matters for the consumer might not matter for central banks and investors. Central banks in the late '70s and early '80s had to deal with wage inflation and 'kill' inflation expectations. Higher interest rates were helpful in that regard. Today, the cause of inflation is not something that central banks can do much about. The rise in commodity prices reflects to a large degree structural changes in both supply and demand. Monetary policy cannot address demand/supply imbalances and raising interest rates will not make them disappear (unless the authorities are willing to risk a major economic recession). The behaviour of the bond market shows that inflation expectations remain reasonable at around 2.5%. Why would an investor buy a 10-year Bund yielding 4.5% if he/she were convinced that inflation would stay at 4% or higher? As long as inflation expectations and unit labour costs remain contained, one could argue that it is irresponsible for central banks to raise interest rates and risk a major economic contraction.
What are the implications for investors? First, the Federal Reserve Bank will not be raising interest rates anytime soon. On the contrary, additional rate cuts cannot be ruled out if the economic outlook deteriorates significantly. Second, unless a fall in energy prices leads to a rapid improvement in headline inflation, the risk remains that the European Central Bank will increase rates further despite signs of economic weakness in the eurozone. The more so since the risk of rising labour costs is higher in Europe. Third, quality bonds at yields above 4.5% (using the German Bund as a reference) are attractive as a hedge against deflation. Fourth, deflation is a major risk for equity markets because it would lead to both declining earnings and a contraction of multiples.
