INFLATION is back, or so the markets say. Market-measured inflation expectations for the United States have risen sharply over the past two months, and though the measure might be discounted on its own, there is more to the picture. The past few months have ushered in a global bond sell-off, a marked reversal of the prolonged frenzy that dropped more and more bond yields into negative territory as investors piled into the asset class. Oil prices — which plummeted in 2014-15, dragging down overall prices with them — appear to have stabilized, along with those for industrial metals.
Similarly, factory prices in China seem to be recovering for the first time in years, an improvement that could eventually reach the rest of the world. Assuming these signals are not false alarms but harbingers of inflation, the global economy may be in for a big readjustment in 2017.
Though inflation never really disappeared, particularly in emerging economies, over the past several years it has ceded center stage to deflation, the global economy’s current bugbear. After the 2008 crisis, governments sprang to action, printing and spending more money to stave off a repeat of the low-growth deflationary depression that swept the global economy in the wake of the 1929 Wall Street crash. For a few years, this strategy worked, but it began to falter in 2012. Shortly after they began, the flows of government spending dried up, leaving only money-printing to fight off deflation, and inflation dropped well below target in the euro area and the United Kingdom. Weakening inflation spread to the United States in 2014 as the price of oil began to tank. Meanwhile, Japan — having never recovered from its own 1991 depression — remained mired in low inflation as it had for the past quarter-century, offering policymakers a cautionary example about the dangers of a deflationary slump.
China’s turn for the positive
Various factors conspired to create these deflationary pressures, and like everything in the global economy, they are all linked. A surfeit of supply and a lack of demand have driven down the price of commodities worldwide, a phenomenon for which China is partly responsible. As the “workshop of the world” in the period just before the 2008 financial crisis, China created huge demand for commodities, which it turned into products and shipped abroad. After the crash, China picked up some of the slack left by flagging global demand, pouring money into its domestic housing construction and infrastructure sectors. The investment boom reached its peak around 2012, when prices of input commodities such as iron began dropping, taking Chinese producer price inflation below zero. Before long, central banks in developed economies found themselves struggling once again with low prices as ever-cheaper Chinese products arrived on their shores.
Then, in September, Chinese producer prices broke back into positive territory for the first time in four years, a feat no doubt linked to commodity prices, which have stabilized this year. Crude oil has been bouncing above $40 per barrel since April, a considerable improvement over the $26 per barrel low it hit in January. Although oil prices have stayed stable so far, they are unlikely to climb any higher than the $50 or $55 per barrel rate they reached in October unless OPEC significantly alters its production strategy during its Nov. 30 meeting. At most, the cartel will probably cap production at the levels it maintained in August, limiting any spike in prices. Nonetheless, oil is well above where it was in the first quarter of the year, so year-on-year data will show a sizable percentage of energy price-induced inflation.
A dramatic entrance
The global bond sell-off in October can be largely attributed to the expectation that this trend will continue. Rising inflation is an undesirable prospect for bondholders, who receive a set return in cash that could soon start to lose its relative value. If the concerned investors are right, the effects of resurging inflation could be dramatic. After spending much of the past few years jiggering with the global economy to try to generate inflation, the world’s central banks will have to adjust their policies to accommodate the new conditions.
The United States
For the past 12 months, global markets have been holding their breath in anticipation of the first increase in US interest rates since the one late in 2015 that caused turbulence at the start of this year. The Federal Reserve initially had been expected to raise the interest rate four times in 2016, but the outlook for weak inflation stayed its hand. An increase in global inflation would likely increase the urgency behind the US rate-raising cycle and the regularity of rate hikes. Because many of the world’s emerging markets have linked their currencies to the dollar, the accelerated tightening could create problems around the world.
The Euro area and Japan
Of the world’s major central banks, the European Central Bank and Bank of Japan have been the most active in recent years. Inflation is still far off target for the institutions, prompting them to try increasingly unorthodox policies. Both have dropped their interest rates into negative territory while undertaking ambitious bond-purchasing programs. An improved inflation outlook would ease the pressure on the banks, which might scale back their quantitative easing programs in response. (Already, the Bank of Japan has changed its direction with quantitative easing somewhat.) In Europe, where ultra-loose monetary policy has inflamed tensions between the central bank and Germany, this would be a welcome development, though it could come with its share of dangers. Countries on Europe’s periphery are still saddled with debt, and the European Central Bank’s quantitative easing program currently provides a backstop to their bond yields. The end of the bond-buying program, however, would sharply increase the yields, hurting these countries’ budgets. The Bank of Japan, on the other hand, recently committed to buying enough bonds to keep yields predictable, forestalling such an outcome for Tokyo.
The United Kingdom
Since the country decided to leave the European Union, the United Kingdom is in a bracket of its own. In the wake of the June Brexit referendum, the pound sterling has dropped dramatically — down 17 percent against the dollar for the year — though the vote is not entirely to blame for the decline. The pound’s fall is sure to bring substantial inflation to the United Kingdom, regardless of whether the trend continues in the rest of the world. The National Institute for Economic and Social Research recently forecast 4 percent inflation for the country by late 2017, twice the Bank of England’s target.
The specter of stagflation
Inflation has not always been so hotly desired among the world’s developed markets; in fact, for much of the global economy’s history, it has been a fearsome prospect. At the most basic level, a deeply indebted global economy stands to gain from higher inflation, since debt repayments fall as the value of money does. (This explains how Europe’s economies escaped the debt they accrued during World War II.) But with that benefit comes the inevitable risk that inflation could get out of hand, requiring high interest rates to curb it, driving up unemployment and hindering growth.
Based on the global economy’s recent trajectory, high inflation with low growth, or “stagflation,” is a very real danger. The global recovery has been anemic, and it looks poised to stay that way for some time thanks to low investment, weak innovation and inauspicious demographic trends. Should central banks stop their quantitative easing programs, the resulting surge in bond yields could inhibit increased government borrowing and spending — currently the favored proposed solution to stimulate demand and escape the low-growth trap. If inflation is indeed making a comeback after all these years, the world will have to come up with a new way to generate growth while acclimating once again to an inflationary environment.