In the past few years inflation has remained persistently low, particularly in developed markets.
In the United States, the consumer price index has trended downwards, only to recover slightly in the past few quarters, reaching 1.1 per cent in the first quarter of this year versus a peak of 3.8 per cent in 2011. In the euro zone, the CPI has hovered around (and even briefly dipped below) the zero mark in the past 18 months. Thus, the US and the euro zone have significantly undershot their respective central banks’ target of 2 per cent inflation.
Likewise, the Japanese authorities have been grappling with low inflation for more than 30 years. To be able to assess the capacity to see inflation picking up going forward, it’s useful to dissect the factors leading up to the current state. We aim to start that discussion here.
In the aftermath of the global financial crisis of 2008 and 2009, developed economies have managed to creep out of recession, but GDP growth has remained anaemic.
The euro zone also suffered through the sovereign debt crisis of 2011 and 2012, which briefly pushed it back into recession territory. On the whole, the past few years have been characterised by hyped expectations for a return to strong growth, only to see growth and inflation figures undershoot and predictions revised downwards.
Given that energy prices play a key role in headline inflation, oil price fluctuations have clearly had an effect, as early this year Brent crude reached a low of 72 per cent below its 2014 peak. However, despite the Brent recovering strongly in recent months, from US$28 a barrel in January to about $50 currently, inflation expectations as well as sovereign bond yields in the US, Europe and Japan have decoupled and, in fact, fallen to lower levels.
In the euro zone, the persistence of low inflation can be partly explained by the significant slack remaining in many of the region’s economies, with the unemployment rate remaining elevated at 10.3 per cent.
This is less of a problem in the US, which is reaching full employment and is starting to finally see some wage growth coming through.
Thus, it is little surprise the 10-year German bond yield is currently only 5 basis points, although even the US 10-year yield has fallen from a peak of 3 per cent in 2014 down to 1.7 per cent currently. Ultimately, we believe the underlying problem is excess capacity, globally and in a number of sectors.
A lot of manufacturing equipment, energy and mining infrastructure and housing were built in the lead-up to the global financial crisis, as well as in the aftermath (particularly by China) in an effort to stimulate a recovery. The result has been a glut of supply at a time when the world’s growth engine (China) has been witnessing a pronounced slowdown, as its economy is in the process of transitioning from fixed-asset investment to consumption-led investment.
The excess capacity has caused pricing power to remain elusive, more so in sectors such as industrials and utilities, and less so in the telecoms and technology sectors.
The Federal Reserve, the European Central Bank and the Bank of Japan have all been accommodating in an effort to bring inflation closer to their target, with the latter two still actively engaged in a programme of quantitative easing and ready to be even more aggressive to stop disinflation from becoming entrenched.
However, we believe the key issue is that imbalances in the global economy remain and it will take time to work through them.
For inflation to trend towards the 2 per cent mark, developed economies will need to continue along their growth profile, allowing central banks to raise interest rates and finally signal a return to “normality” after the global financial crisis, which we think would help inflation expectations – and therefore inflation – to go higher. Given where it is in the economic cycle, the US seems closer to this goal, but the past few months of false starts have shown the ride is likely to continue to be bumpy.
Rajesh Tanna is a senior portfolio manager at JP Morgan Private Bank and Christopher Laskaridis is an assistant portfolio manager