If the world is to move into a period of widespread deflation, the price falls we have already see...
If the world is to move into a period of widespread deflation, the price falls we have already seen in the goods sector will need to be extended to the services market.
Other parts of the global economy, notably the US, will be required to succumb to the forces causing deflation in the countries in which it is currently being experienced.
There is a risk this could occur, but there are also good reasons this is not the most likely outcome. In the countries that have been experiencing deflation, such as Japan, China and Hong Kong, local factors have contributed significantly.
In Japan, for example, the weakness of the financial sector helped prevent monetary policy working in the early stages. Now, deflation has intensified to the extent there is no loan demand. Even if the financial sector were stronger, it is questionable whether monetary policy can be effective in bringing deflation to an end. Fiscal policy in Japan has also been used to try to avert deflation but has been applied in ways that have failed to stimulate private sector domestic demand and has been ineffective.
Hong Kong's deflation is related to the fixed exchange rate with the dollar. With its regional competitors having benefited from their currencies depreciating at the time of the Asian crisis, it has had to regain competitiveness by lowering its internal prices. Once competitiveness is restored, demand should start to recover and prices should stop falling.
The forces of deflation can be overcome either by continued consumer spending or the right set of policy responses. Looser monetary policy has already helped sustain consumption, particularly in the US and the UK, despite severe difficulties in the corporate sector.
Fiscal policy is also being loosened in both countries and the US is poised to unleash another round of tax cuts now the Bush administration has strengthened its influence in Congress.
The Fed may be running out of ammunition in the form of interest rate cuts but has other means, such as injecting liquidity directly into the economy, that will be used if necessary. Unlike Japan, monetary stimulus is getting through the banking system and is being used to sustain growth.
We have more concern about Germany, where the economy is suffering from weak domestic demand, and the eurozone as a whole, where policy responses are constrained by the rules governing the region. At least the ECB has finally provided some relief with its first interest rate cut in more than a year.
We expect globalisation trends to keep downward pressure on prices of traded goods and services. However, domestic conditions are supportive for moderate inflation in non-traded goods and services prices.
Financial markets have been behaving in a way consistent with a transition from inflation to deflation. Even if this turns out to be the outcome, equities can outperform bonds in the medium term, once expectations have fully adjusted to the reality.
In the more likely event the global economy can avoid such an outcome, bond yields should move slightly higher and equities should start to recover some of their losses.
Global economy should avoid deflation.
Equities should outperform from here.
Yield on bonds to be higher than on equities.
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