Still Nothing To See Here

18/10/2013 at 5:10 pm

Three months ago we had a look at US price behaviour, noting that inflation should be expected to rise as the labour market recovers and GDP growth returns to trend. This is not an expectation confined to America of course. And absent an unlikely-looking statistical surprise, data for Q3 will show that GDP grew across all of the major developed economies.

Should this be the case it will be the first time that the economies of the US, the eurozone, Japan and the UK have all grown for two consecutive quarters since Q3 2010. (The east Japan earthquake and renewed contraction in Europe saw to that.) This is good news, of course. But as the UK housing market, or the freight index we looked at a few weeks ago should be reminding us: stronger growth increases the risk of inflation.

Now inflation has not been a concern for the developed world lately. US CPI briefly pushed up to 4% in 2011 on the back of dollar weakness and rising oil prices, while the more persistent erosion of real wages in Britain over the same period saw the household sector back in recession. Since then, however, prices have been rising at much slower rates.

Looking back more broadly, price behaviour has not been a pressing issue for the past 20 or so years – other than in Japan, where deflation has notoriously been a symptom of persistent economic malaise. Returning to the US as an example, the average rate over that period was 2.4%, compared to 6.2% on average for the twenty years before that (1973-1993).

The longer term picture is interesting. Older City hands who worry more about inflation remember the 70s and 80s, and are as behaviourally anchored to their personal experience as are we all. Twenty years is a long time. Against this more recent background it becomes easy to understand why such worries do not seem to be widely shared.

Reasons for the relatively benign inflation of the last two decades are varied. The development of the online market place from the mid-1990s and the outsourcing of the production of goods to the developing world have been often and rightly cited as examples for some time. But there is another very important reason why inflation stayed broadly contained: monetary policy was used to contain it. In 1994-5 the Fed doubled its target rate from 3% to 6%; here in the UK the Chancellor, and then the Bank of England, raised rates from 5.25% in 1994 to a high of 7.5% in 1998. A few years later, as growth recovered from the TMT bust, the entire developed world tightened policy: from 2003 to 2006 the Bank of England, Fed, ECB, Bank of Canada and Reserve Bank of Australia all hiked rates and even Japan ended its zero interest rate policy. (Most dramatic was the move in the US, where the target rate rose from 1% to 5.25% over two years.)

Perhaps this makes an obvious point. While we can be forgiven for having got very used to low inflation, however, as investors we should not be forgiven if we forget what underpinned it. Important factors as they were, it wasn’t just a case of China and the internet. And if we think that even extremely significant technological advancement (such as horizontal fracking) can do the job of managing prices on its own we are kidding ourselves.

To reiterate one point from three months back, we do not seem to be in danger of an immediate inflationary spike. But the economic landscape has changed for the better this year. The natural direction for inflation in developed economies will not be down for much longer. Central banks should and must respond accordingly if seriously uncomfortable price behaviour is to remain a thing of the past.


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