Don’t dismiss inflation
- A running theme at the IMF meetings was the policy room available due to the lack of inflation
- The inability to hit the 2% inflation target by G3 central banks is indeed striking
- Idiosyncratic, structural, and cyclical factors are playing into the disinflationary narrative
- But many factors that could drive up inflation are present as well
Can muted inflation last?
The inability of G3 central banks to generate 2% inflation on a sustainable basis, despite unprecedented fiscal and monetary support over the past decade, is under renewed focus. Should the ECB forget about rates normalisation and engage in further QE? Should the Fed send out further dovish signals by entertaining “average” inflation targeting over the cycle? Should the BoJ monetise debt in an even more explicit manner? These questions are being heard in the panels and side-lines of the ongoing IMF/World Bank Spring meetings in Washington DC.
There is consensus that reasons behind muted inflation are many. They include idiosyncratic (rise of e-commerce), structural (aging), and cyclical (output and employment gap in Europe) factors. Inflation expectations are low, and central banks’ credibility to lift them is under threat. Moreover, because of a lack of pricing power (thanks to the competitive pressure from the likes of Amazon and Wall Mart), a rise in input price or wages does not readily materialise in retail price increases. Typical sources of headline inflation shock, food and fuel, have had their ups and downs in recent years, but have not lasted long enough to cause a change in expectations.
For large, advanced economies with reserve currencies, the question then becomes if persistently low inflation and lacklustre growth (due to aging and weak productivity) mean low nominal growth, with associated risks of zero bound in monetary policy, liquidity trap, rise in inequality (with return on capital outpacing the return on labour), and general economic malaise. Increasingly, the answer appears to be yes, with notions of “secular stagnation” setting in.
As these views become conventional, the policy implications turn more and more unconventional. If interest rates are likely to remain exceptionally low, and if a government can issue long duration liabilities at historically low cost, ever larger fiscal deficits and debt/GDP ratios can be entertained. If inflation expectations cannot be raised by easy monetary policy, perhaps the central banks should target higher inflation rates, or give clear signals that even if inflation exceeds the target for a while, policy rates will not be adjusted upward.
We find it striking that only a few months ago, with the Fed hiking rates and ECB heading toward rate lift-off, it had seemed that the inflation outlook was sufficiently constructive. But now, the narrative has shifted back yet again to one of no major inflation impulse in the global economy. While financial market conditions are back to where they were in October, when the Fed was signalling many more rate hikes to come, expectation has shifted to no further hikes in this cycle, and the Fed’s communication is now about dealing with downside risks to growth and inflation.
But is the picture really that dismal? How has global inflation evolved over the past decade? In the following chart, we look at US and EU inflation (headline and core) since 1999. It clearly shows that headline inflation has trended down this decade relative to the previous one, but the evidence is not that clear when it comes to core (taking food and fuel out of the index) inflation.
US core inflation fell in the aftermath of the 2008/09 global financial crisis, but has been around 2% in recent years. When one looks at the cost of healthcare, rentals, education, and a broad range of other services, there is in fact little sign that inflation has dissipated. Aging, globalisation of production, and reduced pricing power have surely pushed down the frequency and magnitude of price adjustments, but the supply-demand dynamic for many products beyond food and manufactured goods points to price rises at least in line with wage growth.
What about the key economies in our Asian backyard? Here, there has been a sharp disinflation phase for India and Indonesia, with both economies leaving their double-digit inflation track record well behind. Indeed, presently headline inflation rates in both economies are well below the inflation target of their respective central banks, hovering below 3%. Food prices have been exceptionally stable in recent years, while fluctuations in energy prices have been passed through incompletely (and with a lag). Core inflation, however, is above 5% in India, while over 3% in Indonesia, having bottomed early-last year.
China and Singapore have displayed fairly similar inflation patterns in recent decades, despite rather different price formation behaviour and inflation index weights. But periods of low inflation and sharp dis-inflation are hardly rare, looking at long-term data. Meanwhile, core inflation trend has shown no change whatsoever over the past two decades in either country, hovering around 1.5-2%.
With macroeconomic policies highly supportive in China and the US, employment conditions strong in most key economies, cost of production rising in China, and commodities showing signs of buoyancy, this is no time to give up on the chance of a cyclical pick-up in inflation, in our view. We fully appreciate the structural factors keeping prices at bay, and recognise the challenges faced by major central banks in reviving inflation expectations, but from a cyclical perspective, we would argue that the world is not standing at the precipice of serious deflationary forces.
Highlights of the week:
• China: Higher CPI will not tighten policy
• HKD rates: Low aggregate balances to gently lift Hibor
• South Korea & Taiwan: Tentative signs of a bottom
• Chart of the Week: Singapore GDP and MAS meeting are the focus this week
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