Last week, in his final inflation report press conference, Mervyn King announced that the Bank of England had reduced its forecast for inflation and increased its forecast for growth.
Inflation is running at just 1.1% in Germany, at 1.5% in Spain and just 0.8% in France. Indeed if the impact of indirect tax increases is excluded, inflation is even lower in the eurozone. The US reported inflation data for April this week and the CPI was just1.1%, falling from 1.5% in March. 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.
Modelling inflation is hard
The theoretical underpinnings of inflation modelling are compelling but the empirical results are not that convincing. However, in the past 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 most recent business cycle – at the end of 2007 – very few countries have been able to recover all of the lost 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) or 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. 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 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.
Ongoing lending pressures
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.
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.
