Deflation: No ordinary accident

Around the globe, central banks fear deflation will be almost as big a risk as inflation for the next couple of years. It's not only the GFC that's brought the world to this point.

Global markets are still coming to terms with the fact that inflation is dead. For investors, the environment of entrenched low inflation means that average annual returns above 5 per cent will look terrific. While inflation stays low – or as seems likely, falls further – annual investment returns under 5 per cent will be more likely than not.

It has been more than two decades since the world had a genuine inflation problem. Inflation is low throughout the industrialised world and the current central bank fear is that deflation (a period of falling prices) is almost as big a risk as inflation over the next couple of years.

This is one reason why we are currently witnessing the most stimulatory monetary policy the world has ever seen. Interest rates in the G7 and in some other industrialised countries have been set at or near zero, there are trillions of dollars, pounds, euros and yen being printed and pumped into the banking system and there is no end in sight to this super stimulus. Indeed, many central banks in the industrialised world are extending the monetary stimulus with open-ended quantitative easing.

In the US, annual core inflation has been at or below 2 per cent for almost five years and there have been only two months in the last 15 years that it has been above 2.5 per cent. The most recent data show core inflation in the US decelerating towards 1.5 per cent after a short-lived 'jump' to 2 per cent early in 2012.

In the eurozone, core inflation has on average been even lower than in the US. It has been a decade since the annual rise in eurozone core inflation has been above 2 per cent and, for the last three years, it is averaging 1.5 per cent – which is where the most recent reading for core inflation sits.

In Japan, deflation is entrenched. This experience is yet to be repeated elsewhere and owes something to Japan’s demographic problem of low population growth and aging. That said, the recessed economy and policy failure in Japan means that the annual change in core inflation has been negative for all but six months in the last decade and in the last four years, the average annual rate of deflation has been around 1 per cent.

Inflation is also very low in Canada and the UK, even though the Bank of England faced a mini-inflation issue a year or two ago which was associated with the collapse of the pound.

This extended period of low inflation in the industrialised world has been driven by a range of influences, some deliberate, some accidental.

In the period up to about 2007, central banks targeted inflation with their monetary policy settings. It seems a while ago now, but that was when central banks hiked interest rates when there were signs of strong economic growth, capacity utilisation pressures and when the labour market was tightening. It cut them as these events reversed. On balance, the world’s central banks did well in meeting their targets in the period up to then.

This was helped, it must be noted, by the emergence of Asia in general and China in particular as low cost producers of manufactured goods. China was "exporting deflation to the world”, or so the saying went, and with it production of cheap clothes, electronic goods and other consumer items.

In the last five years or so, the story has been different. Central banks have been combatting recession and at various times, deflation. Monetary policy in the G7 countries has been set to super easy as central banks work to inflate their economies as the wreckage of the worst economic situation since the 1930s Great Depression crunches activity, spending, borrowing, jobs and prices.

With the exception of Japan, deflation has been averted. But there remain lingering doubts that any unexpected economic weakness in the next year or two from such a weak starting point in the eurozone, the US, UK or Canada would spark deflation fears. This is why the Fed, the ECB, Bank of Japan and Bank of England are all doing whatever they can to keep their respective economies growing.

There is one other critical issue that emerges from the current inflation climate. Low inflation makes it makes it harder for governments to repair their budget problems. They are not receiving gains in revenue from higher tax receipts, as wages growth is also being held back. Nor are companies growing profits, on average, much above the growth in nominal GDP. Consumption taxes also grow slowly due to the selling prices of goods and services being flat or rising at a very moderate pace.

A little bit of extra inflation would help the sovereign debt problems around the world. It might also spark a lift in consumer and business confidence. Unfortunately, for the near term at least, it looks like inflation will be staying too low despite the best efforts of the G7 central banks to kick it higher.