Deflation – A Hidden Threat

Disinflation or deflation can reflect a sudden surge in productivity or increase in energy supply that drives down headline inflation. However, these factors don’t fully explain why inflation globally is currently so low. Instead, it seems low inflation reflects the waning powers of central banks, whose unconventional monetary stimulus policies have had a bigger impact on financial asset values than on the real economy.

Rather than removing deflationary trends, monetary stimulus seems merely to allow central banks to export deflation to other parts of the world.

Initial bouts of quantitative easing – whether in the UK, Japan or US – were associated with sizeable exchange-rate declines that temporarily lifted inflation in the ‘host’ country. Yet for every exchange-rate decline there must inevitably be an exchange-rate rise. And for those experiencing ‘unwanted’ gains, inflation has ended up lower than expected and, often, lower than desired. Look at the eurozone in the second half of 2013.

Normally, this wouldn’t be a problem. But with domestic transmission mechanisms not working as well as they might, and with growing protectionism, one country’s monetary stimulus is increasingly another’s ball and chain. If unconventional policies work primarily through the exchange rate, they serve primarily to export, rather than cure, disinflationary pressures. At the international level, those pressures refuse to subside.

It is comforting to think low inflation won’t last. However, despite falling unemployment in the US and UK, wage growth remains surprisingly weak. There is a danger of confusing cause with effect. In a standard economic cycle, activity leads inflation. In a post-bubble environment, where debts are high and deleveraging is rife, the opposite applies: excessively low inflation increases real debt levels, hinders deleveraging and eventually suppresses demand and activity. Japan’s modest mid-1990s recovery was ultimately undermined by creeping deflation and premature policy tightening.

This makes it harder to manage the transition from QE to ‘forward guidance’ as tapering takes hold in the US. But if central banks cannot decide whether output leads inflation or inflation leads output, providing clear advice on future monetary policy may be near impossible.

It is against this backdrop that we make forecasts for 2015. We expect global growth to accelerate to 2.8 per cent by then – up from 2.0 per cent in 2012 and 2.6 per cent in 2013. The acceleration reflects a shift from eurozone contraction to modest expansion alongside a more aggressive – although unbalanced – UK pick-up.

At around 2.3 per cent in 2014 and 2.5 per cent in 2015, the forecast pace of US economic recovery remains disappointing. Emerging markets should shrug off some of their 2013 funk, returning to growth of above 5 per cent by 2015, but Brazil remains notably weak.

While not predicting a descent into outright deflation there is a risk that inflation remains too low, or even sinks, over the next two years. Japan’s experience in the 1990s demonstrated that a near-term cyclical pick-up in no sense guarantees the deflation genie has been put back in its bottle.

Forward guidance may increasingly have to focus on the dangers associated with inflationary undershoots rather than on growth overshoots, implying interest rates stay low for longer, particularly in the US and the eurozone.