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Economists are divided on the outlook for inflation, and as the world leaves behind the global financial crisis, businesses too are asking: should we expect solid inflation or deflation?
For the past couple of years, economists have been somewhat divided on the most likely outlook for inflation.
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Some argue that demand will be so weak coming out of the global financial crisis (GFC) that there will be insufficient spending to generate upward pressure on prices.
Concerns about deflation linger, and some economists see the Japanese experience of extended weakness in demand and negative price growth as the likely blueprint for major western economies.
Others are concerned that the outcome of expansionary economic policies put in place by authorities worldwide will be higher inflation. Massive government spending programs, sustained low interest rates and efforts to inject cash directly into the money supply will, they argue, prove to be inflationary.
The debate is proving to be a particularly fluid one.
EXPECTATIONS OF INFLATION ON THE RISE
In recent months, the pendulum appears to have swung towards those in the inflationary camp. An indicator of market expectations around inflation is the gap between government bond yields and the ‘real’ yield offered on government-backed inflation-linked bonds.
Before the GFC, inflationary expectations in the United States hovered between 2 per cent and 2.5 per cent. Expectations then swung quickly in the other direction, with deflation the brief consensus forecast at the height of the GFC.
Expectations then moved steadily back towards normal but declined again in the middle of last year when European debt concerns dented confidence.
In recent months, inflationary expectations have returned to the 2 per cent range.
Confirmation that the US Federal Reserve was initiating a US$600 billion injection of funds into money markets as part of its quantitative easing program, has promoted the view that new effective purchasing power within the US economy will push prices higher.
In Australia local inflationary pressure could be affected by such a development.
PRESSURES ON INFLATION LOCALLY
Locally, the Reserve Bank has been concerned for some time that the mining boom could generate labour shortages and capacity constraints in parts of the economy. These could lead to more general wage increases across the economy which would provide an added impetus to inflation. The recent floods will also restrict the supply of various agricultural goods.
A 2.8 per cent increase in the Consumer Price Index over the year to September was recorded despite low global inflation, weak consumer spending and a high Australian dollar. Hence, there would appear to already be some underlying inflationary pressures in Australia that could be stoked further should global inflation increase.
IMPLICATIONS FOR INVESTORS
While a rise in inflation may be accompanied by rising interest rates, it generally reduces the attractiveness of interest bearing investments, with the purchasing power of cash and these investments eroded.
Growth investments, such as property and shares, may be preferred in a higher inflationary environment. Also, underlying rental and profit streams tend to increase as inflation rises, supporting higher share and property prices. Investments such as infrastructure and property, where large fixed costs have already been incurred, may be particularly strong performers as revenue rises in line with inflation but there is no corresponding change in a majority of costs associated with the investment.
