A year ago, markets were obsessed with the threat of global deflation. The headlines were full of tales of Germany plunging into a lengthy period of deflation and the unending flat line of Japanese growth.
Now, a mere 12 months later, the pendulum has swung back and concerns are shifting to the risk of resurgent inflation as the world adjusts to a continuing stream of higher than expected growth figures. Is renewed inflation a serious worry for investors or is the danger just one of a short-term over-reaction in financial markets?
In our view, the latter is more likely. We expect global inflation to accelerate only moderately and this prospect is substantially reflected in current market levels. Bond yields have already adjusted upwards in anticipation of a period of higher short-term interest rates, particularly in the US after the Federal Reserve announced a quarter-point increase last month.
In turn, firmer bond yields have held back equity markets during the first half of this year, offsetting the favourable impact of rising corporate profits. With this in mind, we are forecasting that most bond and equity markets should produce positive total returns from current levels over the next year.
The upward pressures on prices are short-term cyclical ones. Expansionary fiscal and monetary policies have produced a strong upswing in global economic activity. Spare capacity and slack in labour markets are being steadily eliminated. In some industries, strong demand has exposed the inadequacy of capital spending in recent years.
The extent of the upward pressures on prices will be reduced as higher interest rates and yields lead to some slowing of global growth in 2005 and a more marked deceleration of activity in 2006. The OECD leading indicator of global growth has started to show smaller month-to-month rises and, as a result, the most commonly used measure derived from it – the six-month annualised change – is now peaking out.
Projected GDP growth in the main industrialised countries of 3.1 per cent in 2005 and 2.5 per cent in 2006 would be respectively a little above and still close to trend. However we expect that the pace of growth will have fallen clearly below trend by the end of the latter year, with only a 2 per cent rise over the year to the final quarter. Slower growth in 2006 primarily reflects the rise in global interest rates that is now getting under way. The global “output gap” is likely to turn positive for a time but not to the extent seen in the late 1980s or even in 2000.
However, the main arguments against a sustained acceleration of inflation are structural ones. Globalisation and the increasingly important role of China and India will have a continuing downward influence on the price of tra-ded goods and services. Central banks are now relatively independent and more resistant to political pressures than they were in the past.
Finally, inflationary expectations are now quite low and well anchored. Taken together, the last two points argue strongly against the re-emergence of anything resembling the sort of wage-price spiral seen in the 1970s and 1980s. We expect that average “core” inflation in the main groups of advanced economies will move up from its recent figure of around 1.3 per cent but only back into the 1.5-2 per cent range which has ruled for most of the last eight years.
Inflation in the UK is still very low. Even with a sharp jump in petrol prices, the ann-ual increase in the consumer price index was only 1.5 per cent in May, still comfortably below the Government's 2 per cent target. Indeed on one underlying measure – the CPI excluding energy and unprocessed food – inflation in the UK is running at only 1.1 per cent or roughly half the 2.1 per cent pace recorded in the euro-area. An acceleration is likely over the next two years as robust activity gives companies some ability to pass on higher wage and non-wage costs.But the fears of the monetary policy committee that inflation will move decisively above 2 per cent look overdone.
We expect that the MPC will push ahead with another two or three rate rises, taking the level of base rates up to 5 per cent or 5.25 per cent by early 2005. However, that should be the peak, as a softer housing market and a slowing of overall economic growth eventually allow the MPC to take a more relaxed view of future inflation.