Inflation is a critical issue for long-term investors, yet the outlook has never been more uncertain. The downward forces in the U.S. and Canadian economies still look formidable, even though the pace of decline has slowed. Unemployment is rising fast, and industrial capacity use in both countries is at its lowest ever recorded levels. Commodity prices are low, and wage growth is slowing sharply, with increasing reports of pay freezes and even cuts. All this points to declining inflation and even deflation, if the economic downturn is prolonged.
Yet the policy response sounds like a recipe for inflation, particularly in the United States, where stimulus spending is bringing huge fiscal deficits and the Federal Reserve has embarked on quantitative easing — i.e., printing money. A few diehard monetarists are already forecasting a surge in inflation within the next 18 months, while many economists are concerned about the long-term risks.
So is the downturn going to bring us deflation, or are governments going to create inflation? Should an investor regard 10-year government bond yields under 3% as a bubble, or is this level justified by the inflation outlook?
For Canada, there is good news and bad news on inflation. The good news is that we are unlikely to see a major inflation on our own, as has sometimes happened in the past. Canada’s fiscal position is much stronger than in the United States, and the Bank of Canada’s independence is secure. True, a weak loonie can temporarily boost Canadian inflation relative to the U.S., but inflation is not likely to run away. The bad news is that if the United States goes on an inflation binge or (equally bad) is mired in deflation, Canada will follow. Our economies are just too intertwined.
So what about the outlook for inflation in the States? Inflation arises in three possible ways. First, there is the danger of an overheating economy, when it is operating at full capacity and unemployment is low, so wages and prices are bid up by shortages. We should be so lucky. Fortunately, or more likely unfortunately, this scenario is years away, and if we get anywhere close, central banks will be raising rates to head it off.
Inflation can also develop when investors lose faith in the country’s economic policy, particularly fiscal policy. A crisis of confidence leads to a collapse in the exchange rate, driving imported inflation. Sometimes governments welcome a bout of inflation, because it inflates away excessive government and private sector debt, with the fixed-income investor taking the hit. Inflation from this source was a common problem in many emerging countries in the 1970s and 1980s and, indeed, led to hyperinflation in Latin America.
In my view, this scenario will become a major worry during the next year, but will not materialize. The truth is that the U.S. fiscal stimulus legislated in February was Congress’s last shot on stimulatory policy. It has taken the budget deficit to at least 12% of GDP this year, and even the United States cannot run a still-larger deficit without risking a loss of confidence and a currency collapse. But I believe policy-makers will recognize this limitation. So if the economy is still weak next year, or if it relapses after an initial inventory-induced bounce, it will have to be monetary policy, not fiscal policy, that steps up.
There is another problem with the dollar-collapse scenario. What is it going to collapse against? If the U.S. economy is weak, Europe will be weak, and indeed much of the rest of the world will be, too, including Canada. So, unless the American economy and policy balance look a lot worse than in other countries, the greenback can certainly weaken but looks unlikely to collapse.
The third route to inflation occurs when the economy becomes locked into a wage-price spiral, which in certain circumstances can happen even though the economy is weak. The inflation in the United States and Canada in the 1970s was a classic case. But then unions were strong and wage contracts were frequently indexed to inflation. Workers reacted to higher gas prices in 1974 and 1979 by demanding higher wages, and employers and the government obliged. At times, too, there were formal price and income policies that locked wages and prices together in a rising spiral. But in the modern globalized world, international competition is intense and unions are weak. Last year, for example, when oil prices soared again, few people were able to get a higher wage to compensate.
All in all, then, it is not easy to see the mechanism by which inflation could take off again. Of course, monetarists argue that quantitative easing will inevitably feed into higher spending and higher asset prices. Let us hope they are right and it does indeed help the economy recover. But that will not necessarily unleash inflation; rather, it will help the recovery to get underway as business responds by increasing sales and boostingcapacity. Moreover, even if inflation starts to pick up in 2010–11, it will be from a low level. The central banks will have plenty of time to respond by raising interest rates before inflation gets out of hand.
So, rather than worry about inflation moving back up to 3% or higher, the greater risk is almost certainly deflation. Headline inflation in the United States dipped below zero in March as the base effects of last year’s oil price spike took effect.
Canada’s headline inflation is also falling and will likely go negative over the summer. More importantly, core inflation, excluding food and energy, is slowing and looks set to retreat at an accelerating pace as wage inflation slows. By 2010, core inflation will be down in the 0%–1% range in both the U.S. and Canada.
Past experience suggests inflation does not finally bottom until some two to four years after the economy starts to recover. Unless we enjoy a remarkably robust economic upturn in the next couple of years, the pattern is likely to be repeated, with inflation sinking further, even though the worst of the recession is over. So sometime between 2010 and 2012, we should expect a new deflation scare. We saw a similar scare in 2003, about two years after the U.S. economy started to recover from the 2001 recession, which drove the U.S. 10-year bond yield down to its low of 3.1% for that cycle.
The coming deflation scare will be good news, therefore, for investors in bonds. It means that bond yields, now in the 2.5%–3% range in both the U.S. and Canada, are not in a bubble — contrary to the fears of some commentators. It also means that yields will likely go lower during 2010–11, as inflation sinks lower and the risk of deflation rises, giving investors a nice capital gain. In the end, large-scale central bank quantitative easing means that deflation is unlikely to take hold. But that will not be confirmed until 2012 or later.
John Calverley is head of research, North America for Standard Chartered Bank and author of When Bubbles Burst: Surviving the Financial Fallout (Nicholas Brealey, $23.95).