Is the western world on the brink of Japan-style price falls? The merry band of global deflationis...
Is the western world on the brink of Japan-style price falls? The merry band of global deflationists has received unexpected support from official quarters recently. In late April, the IMF ' normally cheer-leader for the world economy ' issued a report warning of a significant risk of falling prices in several countries, including Germany.
This was followed by an unusual statement from the US Fed after its May policy meeting claiming that 'the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pick-up'.
The expressions of official concern encouraged a strong rally in global bond markets, with long US Treasury yields falling to levels last seen in the 1950s. Amid all the excitement, however, the key message may have been missed.
Policymakers' willingness to talk openly about deflation suggests to us that they are confident about their ability to avert it. Countervailing loose monetary and fiscal policies may mean that medium-term risks are now shifting away from falling prices towards a revival in inflation.
There are several valid reasons for worrying about excessive price weakness at present. First, inflation has fallen to uncomfortably low levels in several major economies, so it would not take much to tip the balance towards falling prices.
The US GDP deflator ' the broadest measure of prices ' rose at an annual rate of 1.6% in Q1, while the comparable figure for Germany was only 1.1%. Secondly, there is substantial excess capacity in the world economy, which will continue to bear down on prices and margins in tradable sectors.
Thirdly, private sector debt levels remain at record levels in the US, UK and several other economies. This increases the risk of any fall in prices triggering a negative spiral, as households and companies retrench to prevent a rise in the real value of their debts.
Against these concerns, however, monetary trends are broadly reassuring. Historically, deflation has always been accompanied by low or negative money supply growth. Indeed, the classical definition of deflation refers to a contraction in money and credit rather than a fall in prices per se. G7 broad money growth has been picking up since late last year and is currently running at an annual rate of over 6% .
Interestingly, the strongest rise has been in the Eurozone (over 8%), suggesting deflation risks in this economic region are probably still modest despite the surge in the relative value of the euro. Only in Japan is money growth notably weak, but this has been the case for most of the last decade. Current monetary buoyancy supports our expectations of a significant acceleration in global growth during the second half of 2003. If correct, deflationary pressure stemming from excess supply capacity should lessen. Stronger growth should also underpin commodity prices, while making households and companies more comfortable about sustaining current debt levels.
Simon Ward, investment strategist, New Star Asset Management
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