By Paul rayner, head of UK bonds at SGAM After years of fighting inflation, central banks are cu...
By Paul rayner, head of UK bonds at SGAM
After years of fighting inflation, central banks are currently preoccupied with the risk of deflation, particularly in light of the Federal Reserve's move to reduce interest rates to a 40-year low of 1.25%.
It is important to distinguish between deflation and disinflation and determine if any underlying inflationary pressures are of a cost-push nature or demand-pull, as the implications for financial markets differ. Deflation is a sustained reduction in the general level of prices, while disinflation is a falling level of inflation.
Although Japan's experience is often compared to the current situation, in which the bursting of the real estate/equity market bubble has led to a period of falling prices for the past two years, there are important differences and the other G7 countries will experience a period of low inflation rather than deflation, with Germany the one possible exception. Japan's policy response was slow and its problematic banking system prevented any sustainable growth in domestic demand.
However, the Federal Reserve and the UK's MPC reacted swiftly after 11 September, and again recently, to provide ample liquidity and sustain consumer spending in the face of falling business confidence.
With the ECB reluctant to cut interest rates and the new German coalition government intent on reducing the budget deficit, Germany could easily experience a period of deflation.
The key question for the UK, as far as deflation is concerned, is whether the factors that have driven goods prices lower and service prices higher will remain in place. Excess capacity worldwide remains a major problem and, while the world economy continues to grow below trend, downward pressure on goods prices will continue.
However, we expect the US economy to grow close to trend in 2003, particularly following recent interest rate cuts. We expect some upward pressure on goods prices next year. With interest rates at 40-year lows and unemployment still low, we anticipate no let up in the underlying inflationary pressures in the domestic economy. With the MPC reacting to international events, the risk is that domestic/service inflation will rise further.
Given the Government's desire to improve public sector services we expect there to be upward pressure on public sector wages as witnessed by the recent demands from the firemen, nurses and teachers. Given the current policy mix in the UK and an improvement in the world economy next year, we see no deflationary threat in the UK and would expect the period of low inflation to continue.
Low inflation is likely to be negative for bonds, particularly in light of the risk of increased government issuance next year as budget deficits rise.
For equities, inflation is important, as it is nominal growth rather than real growth that determines the course of corporate profits. Companies have suffered a period in which pricing power has not been evident.
Cost-push inflation in the form of higher wages or energy prices would not be helpful as, given the excess capacity in the world, economy companies are unlikely to be able to pass on higher costs in the form of higher prices.
Inflation to remain under control.
Investor demand remains strong.
Interest rates remain low.
Equities may outperform bonds in short term.
Possible risk of deflation.
Increased government issuance in 2003.
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