• Research

The Upside of Inflation

The global economy is finally emerging from the shadow of deflation, and looking poised for long-term growth.

For much of the past year, excessively low rates of global inflation—so-called lowflation—have kept economists and investors up at night. And the potential for that lowflation to morph into a deflationary spiral? That's the stuff of economic nightmares.

Lately, everyone is sleeping a bit more soundly. That's because concerns about deflation have abated as the global economy shows signs that it's poised for long-term growth, according to a recent report, “From Deflation Scare to Reflation Run," by Morgan Stanley Research's global economics team.

“The stage is set for global reflation," says Elga Bartsch, co-head of global economics at Morgan Stanley. “What the annual forecasts don't make obvious is that inflation is about to, or is already reflating a large portion of the global economy."

While there are still risks to consider, the potential for stable price growth bodes well for financial markets and investors, not to mention countries that remain hungry for some meaningful recovery following the past recession.

Ready, Set ... Reflate

Reflation refers to the set of expansionary economic policies that spur growth and inflation for the long-term and reduce the threat of deflation. Economists typically use the phrase to describe the first part of an economic recovery after a recession.

For many countries, the recovery has been underwhelming, and price increases have ground to a near halt. In fact, nearly 70% of the global economy is in a state of lowflation, which Morgan Stanley economists deemed public enemy no. 1 earlier this year and the biggest threat to global economic expansion. But central banks have been fighting back, and change is on the horizon.

“Things are about to start improving," Bartsch says. “A number of economies have inflected already, and others are sitting right at the trough of their inflation cycles or close to them." Those economies include the Euro Zone (with the exception of Greece), China, Malaysia, the US, Australia, Japan and the UK.

The developed markets drive global inflation. Although many investors still question whether reflation will become a world-wide reality, Bartsch contends that inflation in developed markets bottomed out in April at 2.9% and is now on the rise.

The reflation run is spurred by a rebound in oil prices (from their lows earlier this year), currency weakness in the Euro Zone and Japan, increases in service prices in the US, and improved labor market conditions across the globe, according to the report. “As a result, we believe global inflation should pick up gently to 3.5% by the end of 2016," Bartsch says.

A Long, Slow Run

By the end of 2016, the report projects that only Japan, the UK, China and South Korea will undershoot their central bank inflation targets. That compares to 15 countries that are under their targets now. Nearing 2017, lowflation will hopefully become a thing of the past; the Morgan Stanley economics team predicts inflation could rise to 1.9%, even in economies struggling with lowflation, over the next year.

The inflationary trend might pleasantly surprise financial markets: Their near-term market pricing is much lower than Morgan Stanley's inflation projections. Still, don't expect fireworks. Much like the rest of this recovery, global inflation and growth will most likely climb at a slow and steady pace. 

That's because of two factors: First, different countries are at various stages of their economic cycles. For example, while economists anticipate inflation to pick up stateside, Japan's inflation rate will likely dip significantly due to a recent tax increase. The second is that inflation is less sensitive to traditional indicators of economic growth, such as declining unemployment rates, than in the past.

So instead of rapid global overheating, which would require the central banks to take swift action, we'll likely see a gentle upswing that could extend another four or five years. “If the current upswing lasts until 2020 or so, it would indeed be the longest on record since World War II," Bartsch says.

Keep Your Eye on the Prize

After years on an economic roller coaster, investors would likely welcome the prospect of predictably boring inflation growth. But don't get too comfortable, because we may encounter a few bumps en route.

Consider that the expansionary monetary policy of the world's central banks has helped spur the reflation run. Indeed, Morgan Stanley's inflation projections are based on the assumption that global fiscal easing will continue and that policymakers will take on the structural reforms needed to create more sustainable growth models for the future.

All of this keeps the financial markets happy: risk assets rally and government bonds sell off. But the markets are easily agitated, and investors should expect a tantrum if the economic improvement causes some of the bigger central banks to simultaneously taper their monetary accommodation.

Still, such a fit would likely be short-lived. Those who can keep their eye on the long-term prize—reflation that segues into the sustained global recovery we've been waiting for—stand to benefit.

For more Morgan Stanley Research on global economic trends, ask your Morgan Stanley representative or a Financial Advisor for the full report, “From Deflation Scare to Reflation Run" (June 15, 2015), and more continuing coverage.

Get Your Career Started At Morgan Stanley