Inflation falling as economies struggle to grow as Axa IM’s Chris Iggo considers the policy options

17th May 2013

The inflation outlook in OECD countries appears to be down suggesting central bank interventions will continue according to Chris Iggo, CIO Fixed Income, Axa Investment Management.

In a note to investors, Iggo notes that the consensus says UK CPI inflation has dropped from 2.8 per cent to 2.6 per cent for April with RPI also expected to have fallen.

Iggo also points out that inflation is running at just 1.1% in Germany, at 1.5% in Spain and just 0.8% in France while he US reported inflation data for April this week and the CPI was just 1.1%, falling from 1.5% in March. He adds: “I track inflation data in all OECD countries and the most recent aggregate reading shows that less than 80% of all OECD countries have an inflation rate which is lower than it was a year earlier. This inflation momentum has been slowing since early 2011.”

He notes that inflation is very difficult to model with two schools of thoughts.

Output gap approach

“In the last couple of years those that believe in an output-gap approach to inflation have argued that it is very difficult to see inflation when growth is so weak and when there are large output gaps. Since the peak in GDP in the last business cycle – at the end of 2007 – very few countries have been able to recover all of the last output that occurred in the recession. The level of GDP is only higher than where it was at the end of 2007 in countries like Korea, Australia and Canada. It is modestly higher in the US and Germany, but in the rest of Europe it is either at the same level as it was back then (France) and lower (UK, Spain, Italy). Unemployment rates are still much higher than they were before the financial crisis, which argues against any increase in wage inflation. Taking this approach, one would not be surprised that the most recent trend has been one of disinflation and would not be surprised to see this continue until there is some improvement in global growth rates.”

Monetarist approach

“The recent GDP data from Europe do not bode well in this respect. The other approach to forecasting inflation is to base it on the fact that central banks are rapidly expanding their balance sheets. Monetarists will argue that, eventually, this will result in higher prices. So far it hasn’t, which probably means that central banks feel as if they can continue to boost money growth through asset purchases, and keep nominal interest rates very low as the decline in recorded inflation rates makes it look as though real interest rates are rising again.”

The note adds that the key to inflation is growth and banks. 

“The key to the inflation outlook probably rests with growth and banks. On the one hand growth needs to accelerate to close output gaps and bring down unemployment. From an output gap point of view this would reduce deflationary risks. On the monetary approach, the key is the monetary transmission mechanism and the velocity of the circulation of money. If all the central bank money created by QE just sits in the banking system it is not going to help the economy nor lead to any increase in inflation. This is not a new problem of course. We know that banks need to deleverage. We also can understand why banks do not want to lend when there is negative economic growth and thus a heightened risk of credit losses, especially when they already have dubious assets on their balance sheets and pressure on capital. So of course, the growth approach and the monetary approach are interlinked. Banks won’t lend until there is growth, thus broad monetary and credit growth will remain weak. But if growth does recover and banks regain some risk appetite, lending will also increase and both lower output gaps and strong monetary expansion could shift the risks in favour of inflation.

When will it increase?

“A strong argument can be made that, over the medium term, there will be some increase in inflation. However, that depends on recovery in both output and credit creation. My concern about Europe is that could be a very long time coming. Most of the Euro Area is in recession and is seeing lower inflation. Thus nominal GDP growth is still below the rate of funding for the peripheral economies. Moreover, weak growth, higher unemployment and disinflation can affect behaviour, restraining consumption in the household sector and restraining investment and borrowing in the corporate sector. I have mentioned before that one of the characteristics of the Japanese deflation was a fall in corporate sector indebtedness as companies paid back debt through fear of future declines in nominal revenues. There is no growth in the Euro area corporate bond market – at least at the investment grade level. The ball is firmly in the ECB’s court to do more to affect inflationary expectations and it is in the politicians’ court to accelerate a single banking union.”

Global inflation is partly due to commodities but long term they are unlikely to bring downward pressure 

“The recent decline in global inflation seems to be largely driven by energy price developments. Oil prices have been relatively stable now thus the y/y. change has fallen. Natural gas prices have also been relatively stable at the wholesale level for two years. The impact of shale oil and gas discoveries has been to put downward pressure on the cost of coal. In the US the y/y change in the energy price component of the CPI in April was 4.3%, and that accounts for 10% of the entire CPI basket. I have no idea what will happen to energy prices going forward although the shale story is likely to have a long lasting impact. A meeting with a Chinese economist this week reminded us that, despite the slowdown in the overall growth rate of the Chinese economy and the lower dependence on investment as a source of growth going forward, that economy will still put tremendous pressure on the demand for hard commodities like copper and iron ore, while China is also increasingly becoming an importer of food commodities. The point is that commodity price developments are unlikely to put downward pressure on inflation for a sustained period of time, although it will clearly be important in the months ahead.”

Finally the note decribes what policy success would look like.

“Unconventional monetary policy is all about fighting deflation. It was borne out of Ben Bernanke’s work on Japan and on the US great depression. It has found its most recent incarnation in Abenomics. The stated aim is to make sure that inflation does not permanently undershoot the level of inflation that central bankers think represents price stability (2-3%). So money will continue to be pumped and interest rates will continue to be cut until policy makers are convinced that deflation risks have receded. For the general investment market that means more of the same – higher equity prices and narrower credit spreads. But there should also be a focus on real assets because money is growing faster than output and ultimately the price of money will fall relative to the price of goods and services.”


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