Near-term inflation risks low: analysts

By Steven Lamb | November 19, 2009 | Last updated on November 19, 2009
5 min read

Policymakers in developed economies have employed every weapon in their arsenal to combat the recession, from slashing interest rates to near-zero, to good old fashioned money printing. With the recession now in the history books, market strategists are puzzling out what the result of lax monetary policies will be.

Speaking at the Investment Counsel Association of Canada’s 2009 conference in Toronto yesterday, Pierre Ouimet, chief strategist, UBS global asset management, said the current low-rate environment is simply a continuation of the MINO-policy: Money is no object.

“Everything is being done to make sure the U.S. and global economies are headed on the path to growth,” he said. “Really it’s the mother of all reflation trades that we’re witnessing right now, and the reason for that is because the alternative is so disastrous. The last thing you want to do is head into a period of deflation.”

The ratio of consumer debt to GDP skyrocketed between 2003 and 2007, surpassing 120%. It will take two or three years of consumer deleveraging to get back to trend, at 106.9% of GDP. He points out that the trend since 1950 has been skewed higher by the current era of “free money” and that there is no reason why the trend couldn’t reverse in the future.

“If you drive the price of anything down to zero — in this case, the price of credit — is it any surprise that people will want to own it?” Ouimet asks. “That’s the real problem with monetary policy, is that there’s no real incentive to save, and there’s an incentive to go out and borrow.”

Meanwhile, total public debt in U.S. doubled from $6 trillion in 2003 to nearly $12 trillion at the end of 2009.

“If you’re looking for bubbles around the world, one area where you can start looking is the amount of new sovereign debt being issued and the amount of debt that will be required to finance ongoing government deficits.”

He said there may be some bargains still available on the debt markets, but almost all sovereign debt issued by developed nations is overpriced, with Australia being the exception.

In the U.S., he believes the near-term threat of inflation may be overblown, as almost all major currencies are overpriced against the U.S. dollar. That means the U.S. dollar should rise over, offsetting inflation’s erosion of buying power.

The growing monetary base could generate inflation, but the slow recovery will maintain the current large output gap. He predicts lower inflation over the near term, with a risk of deflation, before higher inflation kicks in.

The U.S. and other developed nations have already used virtually every weapon tool available to “reflate” the economy, and inflation is still not a threat. Policymakers have far more tools at their disposal to fight inflation, should it take hold.

A large jump in the inflation rate should be expected, but not feared, said Christian Broda, director and head of international research for Barclays Capital Management, as it will only be due to the low starting level. Just to reach normalized levels of inflation, there will need to be a large year-over-year increase.

Money aggregates in U.S. have not been rising, Broda said. The supposed increase in money supply generated by quantitative easing measures has not yet fully replaced the nominal wealth that was destroyed in the collapse of the shadow banking sector.

Because of their quantitative easing policies, Britain and the U.S. will be among the first developed economies to raise their interest rates, said Broda, reducing inflationary pressures and boosting their currencies.

Inflation is more likely in China, where money aggregate has grown, and the government is now considering raising the value of the yuan. India will also likely face inflation, as it is subject to fluctuating food prices more than any other sector.

Stock market outlook Equity markets, on the other hand, are largely undervalued, Ouimet said, with the developed world and most emerging markets offering value. The exceptions here are Brazil and India, which he said are overvalued.

“At the bottom of the market in 2009, we were as undervalued relative to intrinsic value as we were overvalued at the peak of the market in the tech bubble of 2000-2001,” he said.

Broda disagrees with Ouimet’s assertion that equities are undervalued, but said global growth alone could drive returns of between 10% and 15%.

“There are a lot of cyclical factors that are pushing toward a healthy 2010,” said Christian Broda.

Current policies are still aimed at a depression level downturn, but most central bankers agree that the recession is over. In fact, industrial production in Brazil and South Korea has been rising since December 2008, while Japan’s began its recovery in February 2009.

“These are not countries that have been highlighted by strong policies,” he said. “These recoveries happened without [stimulative] policies.”

The U.S. and parts of Europe, epicenters of the financial meltdown, probably saw an end to the recession in June. By the third quarter of this year, the global economy was “booming,” Broda said.

“We are not in the eye of the storm; the eye of the storm has passed,” he said. “We need to catch up to the idea that Asia’s recovery has already consolidated. We might have questions about the sustainability of the recovery in G3 and G4 economies, but the rest of the world has recovery.”

Inventories remain low in the U.S., and Broda’s group at Barclay’s predicts that rebuilding inventories will produce seven percentage points of economic growth by over the next 18 months. Even if they are too optimistic, he suggested that five percentage points over the next five quarters would still be strong growth.

“The signature of this recession has been that the collapse of durable and housing goods has been much bigger as a share of GDP than in any other previous recession,” Broda said. “We’re at such depressed levels of economic activity that even our above consensus view implies that we get to the end of 2010 at a level way below any previous recessionary trough.”


Steven Lamb