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Paradigm
shift
The return of inflation - from disinflation to inflation
In the wake of the stock market downturn in 2000 and global
disinflation, which stretched from 2000 to 2002, fears of
deflation emerged in the US. The response to the threat was
immediate and strong: US policy makers brought both fiscal
and monetary policies to bear. The vigour of their policy
reflected their fears of an extended ‘Japanese-style’
period of deflation and implied an acceptance that erring
on the side of growth, and enduring a later rise in inflation,
was a small price to pay for overcoming deflationary risks.
At least part of the rationale for this was that monetary
policy seems better able to deal with inflation than with
deflation.
The policy
worked. Record low US interest rates, coupled with an expansionary
fiscal policy, have stimulated US domestic demand over the
past two years, and exerted downward pressure on the dollar’s
exchange rate. Recent economic figures suggest the period
of declining infla-tion is ending and that the economy is
moving back into a period of inflation growth. In response,
the Federal Reserve is expected to raise rates as soon as
June. Some countries, for example the UK, have already abandoned
their accommodative stance.
Investors’
concerns have turned 180 degrees: fear of disinflation has
been replaced by concerns over the impact that inflation will
have on their portfolios. There is foundation for this concern.
Many of the historical preconditions for a period of high
inflation are in place: global growth is accelerating; commodity
and particularly petrol prices are high; there is ample liquidity;
‘break-even inflation’ priced into inflation-linked
bonds is at a historical high; and there is increasing anecdotal
evidence of a return of corporate pricing power.
These
fears are underlined by recent economic data. The growth in
core US consumer prices has accelerated from a low earlier
this year of 1.1 per cent y-o-y to 1.8 per cent y-o-y in April
(an annualised figure extrapolated from the past three months
data would put the rate of increase at 3.3 per cent). Headline
Consumer Price Index (CPI) inflation has accelerated to 2.3
per cent. A return to high inflation would be costly. Many
investors have large allocations to non-inflation-linked bonds,
with substantial (unrealised) price gains at stake. Their
portfolios are sensitive to a strong pick-up in inflation.
Inflation
is typically thought of in cost-push and demand-pull terms.
Cost-push inflation occurs when factor input costs increase,
and sellers attempt to pass this on to buyers. Demand-pull
inflation occurs when demand for a product or service is sufficiently
strong for the seller to raise prices without direct regard
to costs. The principal causes of inflation in both cases
are: the degree of economic slack (output gap); rate of growth;
competition (including globalisation and deregulation); commodity
price movements and inflation expectations. An analysis of
the strength of the current rise in inflation, and thus the
scenario we are moving toward, must consider these drivers.
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