Annual inflation/deflation briefing
William Bourne has for a number of years written an annual update on the long term outlook for inflation by monitoring shifts in a varied range of inflation indicators. 12 months ago, he suggested inflation would stay at around 1% for the next few years, while noting that the drumbeat of more inflationary times was audible. 12 months later, while not yet a drum roll, it is significantly louder and inevitably approaching.
12 months ago we argued that the US and UK economic and financial systems were not far off returning to normal; that inflation should also return to a ‘normal’ 2% level in the long term; and that, in the short term, the outcome was likely to be a lower figure. This year political and economic changes have prompted a significant change in the environment, which points to a time when inflationary forces will overwhelm deflationary ones. The difficulty is predicting the timing.
We monitored the same 13 indicators this year, and found quite a change from last year’s clear disinflationary message. Two indicators now point to inflation (none twelve months ago) and six to neutral (versus four). It is not surprising that the biggest shift is in the area of policy action: governments around the world are turning to fiscal measures, which will in due course create a significant new source of demand. That is the major change since 2016.
The 2016 rise in the prices of industrial commodities, and oil in particular, will create a short-term push to consumer inflation. It is linked to the stabilisation of the Chinese economy but will not be sustainable for long unless Western economies can generate higher growth trends. Here the picture is discouraging, with the IMF Advanced Economies 2021 forecast at 1.7%, little changed from 2016. Against this, five indicators still point to deflation. There is considerable oversupply of both goods and labour, technology is literally revolutionising service and goods industries, and there looks little likelihood of rate rises, even in the US (despite the Federal Reserve’s recent comments), in the next few years.
I make no apologies for repeating from last year verbatim my comments on the long term narrative. As before, it “…focuses on the level of indebtedness in the West. We said (in 2014) that without growth, governments around the world have a choice between austerity, some form of default or inflation in order to reduce their debt levels. Long term growth forecasts are hovering around the 1% to 2% level, and inflation is more acceptable politically than either austerity or default. It seems inevitable that inflation will be at least part of the solution for most countries. The difficulty for investors is to predict when.”
Nothing has changed here. Growth looks just as unlikely in the West, austerity has been rejected, and the choice has come down to default or inflation. The shift to fiscal policy will increase indebtedness and inflation is now close to inevitable in some form. However, while inflation expectations (eg. bond yields) are starting to reflect this, without a further major shift in political direction inflation levels are unlikely to return to those of the 1970s or 1980s any time soon.
TABLE SHOWING DIRECTION OF TRAVEL FOR INFLATION
The current IMF forecasts for Advanced Economies show little change from last year. Inflation is to rise slowly from 1.1% (end period CPI) or 1.0% (GDP deflator) in 2016 to 2.0% and 1.8% respectively in 2021. Estimates for Emerging Markets over the next five years average out at 4.0% CPI at the same time, compared to 4.5% 12 months ago. US consumer inflation in November, as measured by the Personal Core Expenditure (ie. ex food and energy), was almost unchanged from 2015 at 2.1%.
Bond markets are still pointing to ‘benign’ inflation. For example, the inflation risk premium on ten year bonds is around 2% today, and a decomposition of the current 10 year yield curve suggests that the market 2021 five year forward expectation for inflation (ie. in 2026) is 2.0% in the US and 3.5% in the UKi. This is unchanged from last year in the UK but a slight rise in the US.
The forces for deflation which have dominated the last 25 years are still around but are now countered roughly equally by more inflationary ones. Headline inflation is therefore likely to remain subdued, perhaps around 2%, for the next few years. In the longer term the world is inexorably approaching a tipping point for higher rates of inflation, which is driven largely by the political imperatives of the West’s indebtedness and the pendulum’s slow swing back away from capital and towards labour.
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Source: Analysis by CrossBorder Capital Ltd as at 15/12/2016. Available on request.