A new era of deflation is upon us

Powerful forces of change have been unleashed on the world that will put downward pressure on prices and keep interest rates low for the rest of the decade.

I spent some time yesterday with a young man who has created a new book-publishing platform based in Australia, called Tablo. It’s beautifully designed, has 20,000 authors writing for it, hundreds of thousands of readers, and a couple of months ago the business was valued at $4 million in a seed funding round that raised $400,000.

Ashley Davies is just 21. Needless to say, his operation is based in the cloud and he publishes for free -- readers don’t pay and writers get nothing. The business model is that if the books are published later through Apple, Amazon or some other e-book platform, the author, and Tablo, get some cash (but not a lot).

I mention this not because I think Tablo is necessarily going to transform the world of book publishing, although it might, but because it is one of the thousands upon thousands of cloud-based, would-be industry disruptors that have started up in the past few years, and increasingly in Australia.

This year may go down as a tipping point in the use of cloud computing to attack costs and increase efficiency. It adds to the enormous acceleration in processing power and software development which has led, among other things, to 3D printing, driverless cars and very, very sophisticated robots.

In our KGB interview with David Murray this week, the chairman of the Financial System Inquiry talked about the disruption to banking that he is keen to facilitate through lighter regulation of new entrants while they get going.

Powerful forces of change have been unleashed on the world that have now developed their own momentum -- disrupting industries, replacing many traditional jobs, and above all, bringing down costs and prices.

A new age of deflation is upon us: it might even be the normal state of capitalism, freed from the distortions of war and cartels.

The 20th century was characterised by a succession of inflationary wars and then, as soon as they finished, oil shocks that culminated in a burst of near 15 per cent inflation, leading to 20 per cent interest rates and recession.

Which brings us to the second reason for the current bout of disinflation: oil prices have fallen 40 per cent in a few months because of a massive increase in supply, mainly in the US, thanks also to another form of innovation: fracking and horizontal drilling have unlocked vast reserves of oil and gas and blown away any thought of “peak oil” and almost halved the price of oil in three years.

Obviously there are winners and losers from this oil price crash -- producers lose and consumers win. To the extent that the winnings of the winners are greater than the losses of the losers, global GDP will rise and the world will be better off, but there is a fair bit of debate about how, exactly, this will turn out.

One thing it definitely does, though, is add to the downward pressure on consumer prices that has already been building because of what’s called the third industrial revolution and the advent of cloud computing.

Yesterday National Australia bank’s economists joined those at Westpac in predicting at least one more rate cut in Australia, probably two.

This, after 16 months of record low interest rates already, when you might expect the Reserve Bank to be champing at the bit to get rates up again. And it would be … if there were any sign of rising inflation.

But around the world markets are pricing lower inflation and lower interest rates than they were. Fed fund rate futures are now below the median forecast of the members of the Fed’s Open Market Committee, as shown by this chart from the Financial Times:

Moreover, the US bond yield is now below inflation expectations.

That’s not to suggest the markets are always right, but the tone of the discussion has changed. Markets are becoming increasingly confident that inflation is not an issue despite all the money printing that’s been going on the US, Japan and Europe.

Milton Friedman’s line that “inflation is always and everywhere a monetary phenomenon”, which has guided central banking and financial markets for four decades since he wrote it in 1970, looks to have been entirely discredited now.

In an interview with the Wall Street Journal last week, the Fed’s Stanley Fischer, tried to hose all this down, reaffirming that US rates would rise next year unless inflation “is really heading south”.

Well, the way things are looking right now, maybe it will be.

In fact, I think it’s possible that not only will Australian interest rates be cut next year and US rates not rise, interest rates could stay at this level for the rest of this decade.

Businesses, consumers and investors should prepare themselves for a long period of steady, and possibly falling prices, and very low interest rates.

Prepare how? It’s a bit hard to know since none of us were around during the last period of persistent deflation -- the 19th century -- which was before the invention of central banks, and was muddied by frequent financial crises, booms and busts and bank runs (not that central banks have managed to abolish financial crises).

It’s likely to be a period of rising asset prices, and rising volatility -- a secular bull market punctuated by big corrections, not that there’s anything much new about that: bull markets are always punctuated by big corrections.

And this new era is already being characterised by huge transfers of wealth:

·      from savers to borrowers, because of low interest rates

·      from energy producers to consumers, because of low oil prices

·      from legacy industries to disruptors, because of cloud computing

·      from young people to old, thanks to high real estate prices

And that seems likely to continue.