With inflation in the US currently running at 3% a year, Haydn Davies, chief economist at Barclays G...
With inflation in the US currently running at 3% a year, Haydn Davies, chief economist at Barclays Global Investors, believes the outright risk of deflation in the country is only a distant threat.
Davies says there are two types of deflation. The first is that which comes about through a collapse in demand, whereby firms and households are forced to accept lower prices for their service. The second kind is that which is the result of strong productivity growth. In this case, firms can charge lower prices and still make strong profits.
The distinction between the two is important to the economic outlook, he notes. One way to gauge whether weak demand is threatening to plunge the US and the global economies into outright deflation is to look at the inflation rate for household services, says Davies.
He adds: 'As productivity improves much more slowly in the service sector than in manufacturing, falling prices for household services are unlikely to be the result of strong productivity growth.
'Also, whereas a strong exchange rate can push down the price of imported goods, the price of household services is relatively immune to exchange-rate fluctuations as most services are not traded internationally.'
The longer demand remains weak, the greater the risk of the dangerous kind of deflation taking place, Davies says, but for now fears are exaggerated.
Rupert Della-Porta, head of US equities at F&C, believes interest rates may be cut again. He bases his view on the cautionary statement last month from the Federal Open Market Committee (FOMC) regarding the probability of an unwelcome substantial fall in inflation.
To forestall a risk of deflation, the Fed will delay any rises in interest rates even if the economy begins to show signs of a pick-up, he says. Della-Porta believes there is ultimately more risk of inflation than deflation, as the Fed could fall behind the curve and not respond quickly enough to a pick-up in growth.
'I do not expect deflation in the US because the Fed is so focused and determined to ensure a revival in economic growth,' he says. 'With president Bush adding a further fiscal stimulus, the cumulation of positive forces pushing for stronger growth is enormous in the US.'
He adds Bush does not want to repeat the mistake of his father before next year's election, by getting the war right but getting the economy wrong. As a result, Bush is focusing on making sure deflation does not become a reality.
In April, Produce Price Inflation (PPI) saw a record drop from the previous month due to an 8.6% fall in energy prices. PPI dropped from 1.5% in March to -1.9% in April. However, Della-Porta says this shows deflation risk in the US is not broad based as much of it is due to the fall in energy.
Mike Lenhoff, chief strategist at Brewin Dolphin, says spreads have been narrowing on corporate bonds, which he argues is a feature not indicative of the increasing risk of default associated with deflation.
On the contrary, he says, narrowing spreads are indicative of the decreasing risk of default that accompanies an eventual pick up in the economic cycle.
'Narrowing spreads on corporate bonds have been leading indicators of positive earnings surprises,' he adds.
Deflation is still a distant threat in the US.
Interest rates may fall further.
Decreasing risk of defaults.
Despite improved risk appetite
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