Risk of deflation reappears: Sanlam Investment Managers

Arthur Kamp, Investment Economist at Sanlam Investment Managers (SIM), pictured, writes that disinflation, which has become prevalent in the developed economies, appears set to continue in the near term. As the global financial crisis unfolded in 2008 and into 2009, extraordinarily sharp job losses and a concomitant increase in surplus capacity eroded pricing power.

While higher oil prices initially pushed headline inflation higher, core inflation slowed appreciably in developed economies. In May, core consumer inflation advanced a mere 0.9% in both the US and the eurozone, while deflation continues in Japan. Low core inflation and softer food and oil prices should ensure headline inflation remains contained for the foreseeable future – especially in developed economies.

Meanwhile, fears of a ‘double-dip’ recession have resurfaced. The recovery in final demand is still fragile, requiring government support against a backdrop of surplus capacity in developed markets. Indeed, some analysts fear the implementation of fiscal austerity measures, led by southern Europe, could drive the global economy back into recession. Renewed weakness in demand, as fiscal stimulus fades, could weaken profit growth, depress wages and renew downward pressure on prices.

Double-dip not likely but global economy will slow

While not implausible, a ‘double-dip’ outcome is not our base case. Certainly, the global economy can be expected to slow into next year as global industrial production moderates from its frenetic pace during the first half of this year. However, corporate profits have recovered most notably in the US, where total profits after inventory valuation and capital consumption adjustment advanced 34% in the first quarter a year ago. Further, labour markets have stabilised and modest employment growth has resumed in the US. Meanwhile, monetary policy is likely to remain accommodative for some time to come. That said, credit extension still needs to accelerate and employment growth must increase to sustain final demand.

But even in the absence of a ‘double-dip’ scenario, it is argued that the large negative output gap (when the economy is growing below potential) and a high level of unemployment should ensure sustained downward pressure on prices. High unemployment drives low wage inflation and vice versa. So, a sudden surge in the level of unemployment could result in deflation – a period of falling wages and prices.

However, output gap analysis has limitations. The gap between actual and potential economic growth is based on the historical performance of the economy. But the potential growth rate of the US economy has probably been overstated. The financial crisis highlighted the extent to which capital was not efficiently employed – indeed, a portion of the country’s human and physical capital stock is probably redundant.

Government excess a fertile ground for inflation

In any event, capacity utilisation alone does not provide a complete description of the inflation process. Moreover, while arguments that map the path to a world of sustained low inflation or even deflation are compelling, we should not ignore the potential risks associated with the rapid increase in debt levels in developed markets. History is littered with episodes of turmoil and government excess that ultimately proved to be fertile ground for inflation.

Hyperinflation in the 20th century – and there have been a number of these instances – coincided with rapid expansion in money supply. Rapid escalation in the size of government deficits, financed by printing money, were central features in episodes of sharply higher prices and/or hyperinflation. However, hyperinflation seems a highly unlikely outcome in the current scenario. Still, with government’s influence steadily expanding, it is going to be increasingly difficult to maintain the productivity levels that resulted in disinflation over the past decade.

It is no coincidence that the era of disinflation since the 1990s has been accompanied by less government involvement. Relatively more government involvement in an economy crowds out the private sector, which risks lowering productivity. In turn, decreasing efficiency/productivity could boost inflation.

Also, the real test for monetary policy still lies ahead. The Fed Chairman is confident that accommodation extended in the wake of the credit crunch can be unwound and communication from the Fed reminds us that the monetary authorities will be vigilant on inflation. One potential problem is that the Fed may be more fearful of deflation than inflation.

 The US core inflation rate is very low and the Fed is probably wary of the risk of ‘bad deflation’ – falling inflation against the backdrop of a substantial debt overhang. The Fed funds target rate is virtually zero. Falling prices would imply a rising real interest rate, which would be a most unwelcome development in the current environment.

Further, the US unemployment rate is likely to remain high for an extended period. Against this backdrop the monetary authorities may err on the side of maintaining an accommodative stance for too long. Similar arguments hold for the rest of the developed world.

Overall, in the developed world surplus capacity, weak broad money supply growth, high unemployment rates and downward pressure on wages imply little threat to inflation in the near term. However, there is no room for complacency. While disinflation continues in the near term, long-term inflation risk is not negligible. Meanwhile, among emerging markets core inflation has already been increasing in a number of countries (see graph). So expect central banks in some developing economies – especially where there is limited surplus capacity and monetary policy is still exceptionally loose – to tighten monetary policy in the year ahead.

Sim sense’s bottom line

Core inflation has slowed appreciably in developed markets but is on its way up in emerging markets. This again raises the fear of deflation in the developed world.

The main argument behind the possible unfolding of a deflationary scenario is the potential renewed downward pressure on employment against the backdrop of a high level of surplus capacity (when an economy grows below potential) should the global economy experience a ‘double-dip’ scenario.