Abu Dhabi, UAEThursday 21 June 2018

Search for inflation proves elusive for central banks

Low inflation picture could be caused by weak global growth

The global economy looks to be on a constructive trajectory, rebounding in 2017 after bottoming in 2016.

The growth is broad-based and well synchronised between developed and emerging markets. Although central banks have begun considering their exit plans from ultra-easy monetary policy, inflation has yet to emerge and is keeping central banks in check. A stronger and more persistent trend of rising inflation will be needed for a decisive leg up in rates.

Inflation has fallen globally with the pace of price rises “below target” in almost all of the 26 inflation-targeting economies. Barring the UK, where a weaker currency has translated into inflation running at above 2.5 per cent, inflation in G10 countries has remained below 2 per cent for most of this decade. This is despite solid GDP growth and improving employment levels. In the US, the market under most scrutiny, headline inflation fell to 1.6 per cent in June from 1.9 per cent a month earlier and even higher at the start of 2017. In the euro zone and Japan, the trend is broadly similar.

The inflation picture in the key emerging markets is slightly different. In countries such as Brazil and Russia, inflation has been declining as prolonged recession in these economies comes to an end. Central banks in both countries are likely to continue their monetary easing cycles. China is still growing at a fairly robust pace with core inflation fluctuating between 1 per cent and 2 per cent over the last two years. Significant overcapacity in industry suggests, however, that a sustained uplift in prices will be a slow process. In contrast, inflation has moved higher in economies that recently experienced currency weakness, like Turkey and Mexico, but this will likely be temporary and fade once higher import prices have filtered through to the economy and the currencies stabilise.

Getting inflation right is critical for central bank policymakers. Too high and excessive price levels limit consumption, but when inflation is too low companies will be hesitant to invest and consumers may delay purchases, also threatening consumption on the downside. Textbook wisdom links inflation to changes in employment levels, financial system liquidity and supply and demand for goods. However, none of these dynamics provide a good answer to explain the current lack of inflation in the developed world.

Unemployment levels in the US and UK are currently at two and four-decade lows respectively, but wage growth has consistently remained at or below 2.5 per cent. Part of the reason is the influx of cheap labour, either by importing labour onshore or exporting jobs offshore (and hence lower cost production) from markets such as China and India that keeps employees’ bargaining power minimal despite tight labour conditions. Moreover, over the past decade there have been profound labour-market reforms. Widespread unionisation of the private sector has largely dissipated, along with collective wage bargaining that many blamed for helping to fuel wage and price spirals in the earlier decades. They have been replaced with minimum-wage legislation and an increasingly casual labour force – the “gig economy” – that is much more flexible to changes in the wider economy.

Nor is a shortage of liquidity to blame for current low inflation levels. The US monetary base rose at an annual rate of 9 per cent from 1985-95, then slowing to 6 per cent in 1995 to 2005. Consumer price inflation (CPI) during this time was 3.5 per cent between 1985 to 1995 and then slowed to 2.5 per cent in the decade to 2005. From 2005 to 2015 the monetary base soared at an annual rate of 17.8 per cent (from US$1 trillion in 2007 to $4tn in 2015), but CPI increased at an annual rate of just 1.9 per cent.

That leaves supply and demand dynamics as the culprit behind low inflation figures. We believe some key reasons for low current inflation may be related to excess capacity in labour where the participation rate in the US has come down considerably over the past two decades, from close to 70 per cent in the 1990s to less than 63 per cent as of June 2017. The major downturn in commodity prices in the past few years — most evident in oil markets but also in metal and agricultural prices — has also been a result of large increases in supply outpacing demand. At an even higher level, GDP growth globally has been slowing, from double-digit to single-digit growth in markets like China and from mid-single digit to low single digit in the developed world.

There have also been dynamics specific to the most recent financial crisis that have sapped away momentum from price growth. The US Federal Reserve started to offer interest on reserve deposits which meant commercial banks could use the cash to invest in reserve deposits instead of risk lending to corporates. At the same time, regulation became more stringent, leading to banks becoming more cautious in lending.

If the true cause of low inflation expectations is weak global growth; a glut of workers from emerging markets and excess capacity driving down corporate pricing power in many industries then central bankers could be facing a serious challenge to their credibility in the months ahead, as both realised inflation and inflation expectations could take even longer to return to target.

Anita Yadav is the head of fixed income research at Emirates NBD