Global financial markets have moved swiftly from fretting about deflation to enjoying a reflation run, with risk assets rallying and government bonds selling off—at least until the recent market turbulence. We believe reflation, which is necessary for global growth and is, in fact, part of the global liquidity and growth cycles, is here to stay (see chart 2).
Still, many investors are unconvinced: They say the sizeable amount of slack still in the global economy could put downward pressure on wage inflation and thus on consumer price inflation, and eventually on economic growth.
From an economic viewpoint, this debate centers on the nature of the Phillips curve relationship (when unemployment is lower inflation is higher, and vice versa) and the evolution of the output gap, or cyclical unemployment. In this context, we stress that global inflation dynamics have undergone considerable restructuring during past decades and then, again, in recent years. The key structural shift in the relationship that stands out is that, over time, inflation has become less responsive to swings in the business cycle—at least until recently. At the same time, inflation seems to have become increasingly dependent on longer-term inflation expectations.
REDUCED RESPONSIVENESS. The reduced responsiveness of inflation to changes in resource utilization in the economy—together with credible central bank policies that have anchored inflation expectations more effectively—is the main reason why the Great Recession did not lead to another Great Depression and widespread deflation. Instead, inflation held up much better than standard Phillips curve models would have predicted.
Looking ahead, the reduced cyclicality of the inflation cycle suggests that underlying core inflation pressures will likely increase only modestly as the recovery regains traction in the course of this year. In our forecast, headline inflation in the G4 economies makes a sharp comeback in the next 12 months as the negative impact of declining energy prices falls out of the data (see chart 1). Even so, we expect inflation to remain at or below central banks’ 2% target rate. That means the central banks can still pursue an expansionary policy stance and progress very cautiously toward any tightening.
As such, a new, more-muted inflation growth relationship supports our call for the recent upswing to likely be part of a very long economic cycle. While the current expansion is nearly six years old, in our view it could easily extend another four to five years. Not only is the global economy out of sync, as countries are in different stages of their cycle, but it also seems the sensitivity of inflation to stronger growth is still much lower than it used to be. Together, both factors imply a limited risk of a broad-based overheating in the global economy that would force central banks to slow down global growth. If the current upswing lasts until 2020 or so, it would indeed be the longest on record since World War II. This benign monetary policy outlook does not rule out temporary market scares about the new central bank tightening cycle, as seen in the 2013 Taper Tantrum.
Sizeable base effects in the consumer price index since last summer, meaningful upward moves in oil futures in the last few weeks and, in some cases, a material weakening in the euro and the yen, suggest a marked increase in headline inflation in the near term. Once these one-off effects start to fall out of the year-over-year comparison in early 2016, the path of inflation should return to the underlying core-inflation trajectory implied by the Phillips curve relationship. At that point, we expect the inflation trajectory to flatten again and inflation to hover near central bank target ranges and values.
RISKS TO REFLATION CALL. The biggest risks to our reflation call probably come from an unexpected material relapse in demand and from potential abrupt dislocations in currencies. Away from these potential shocks, the balance of risks to these inflation projections seems to lie to the upside. First, notwithstanding the long-term decline in the impact of the output (or unemployment) gap on inflation, there is some evidence that, in recent years, inflation has started to become more sensitive to the amount of slack both in the US and in the Euro Zone.
Reflation, not Inflation
Typically, reflation refers to a set of expansionary economic policies that aim to increase economic activity and reduce deflationary pressures. As such, the term is also used to describe the first phase of a recovery as both growth and inflation return to their long-term trends. Only once the former moves above the long-term trend and capacity utilization starts to increase do economists speak of an upswing. Our discussions with investors suggest that they seem mostly to be focused on the inflation aspect of reflation. In our view, however, it is the growth aspect that mainly drives reflation.
Second, there is uncertainty around the degree of underutilization of economic resources given that output-gap estimates vary widely depending on the methods used. These varying estimates in part reflect an intense debate among academics as to whether the crisis has permanently dampened potential output growth through a prolonged weakness in investment spending and a resulting trend decline in productivity growth. What’s more, the trend line decline in productivity growth seemed to have set in before the financial crisis hit.
Third, there is the possibility of nonlinearities in the relationship between inflation and the business cycle. On the one hand, at very big swings in the business cycle there is some evidence that the impact of very large output gaps on inflation might be nonlinear. On the other hand, there could be nonlinearities when the output gap crosses the zero line, causing sensitivity at that point with respect to the business cycle, due to nominal price or wage rigidities that prevented more material falls in either during the crisis.
Consumer Price Index This index examines the weighted average of prices of a basket of consumer goods and services.
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