Deflation now, inflation later down the road?

By Antonia Oprita

Talk of inflation may seem absurd right now, when everybody worries about deflation. But is this actually the calm before the storm?

The survivors of the devastating earthquake and tsunami of more than 10 years ago in the Indian Ocean have recounted how initially the sea retracted. Some even compared it with a bathtub when the plug is taken out.

Many people were attracted to this bizarre phenomenon and stayed around to watch it – and lost their lives as a result.

Others managed to run early enough to avoid being caught up by the giant wall of water that came crashing down on land after the initial retreat.

What if the same phenomenon is playing out now in the economy? What if, instead of deflation, it’s fast and furious inflation we should fear?

It is easy to dismiss this as simple scaremongering, especially if you’re looking at what’s going on in the world right now: the European Central Bank has changed tack and will start printing money; the price of oil crashed, threatening many companies in the energy sector; yields on the safest debt have turned negative.

And yet – shouldn’t the the negative yields serve as a warning? Why would people pay countries in the eurozone, or even rock-solid companies such as Nestle, for the privilege of lending them money unless they expect a catastrophe?

Deflation seems to have taken over the world. The slow rise, or in many countries the fall of prices has its roots in the period immediately after the financial crisis. But rather than being the disease itself, deflation is just another symptom.

It is the second leg of the fall in demand caused by people losing their jobs or being forced to work fewer hours, or for less money than they would have liked, immediately after the crisis.

Besides the headline-grabbing downsizing by the big companies, which shed jobs by the thousands in the aftermath of the 2007-2009 financial crisis, there was the constant flow of job losses in the small and medium sized sector.

This amplified the phenomenon but was hard to quantify as the losses were a dozen jobs here, a few there.

In many cases, the laid-off people were either hired by other firms for much lower salaries or ended up working as freelancers, on lower pay and poorer conditions, for the employers who had sacked them.

Buying power fell, and demand fell too but did not show up in prices immediately, partly because commodities were held up by institutional investors in search of safe havens.

Seeing deflation too late?

It has taken a while for deflation to become obvious – but just like in the case of the tsunami, maybe we should worry about what it announces, rather than by deflation itself.

There are some signs that some people have begun to worry about price rises a little. In the week that ended on February 11, flows into Treasury Inflation Protected Securities (TIPS) – which protect against the negative effects of inflation — were at their highest since May 2012 – $500 million, data from Bank of America Merrill Lynch show.

A sure sign that risk is back on – and could stoke inflation — is the recovery of high-yield bonds, which last week saw the biggest inflows since July 2013, of $4.2 billion.

High yield bond inflows

High yield bond inflows highest since July 2013. Source: Bank of America Merrill Lynch

Most investors still put their money in investment grade bonds, the absolute winner among asset classes of the central banks’ monetary easing as investors seek safety in an uncertain world.

Investment grade bonds saw their 60th straight week of inflows last week, when they received $5.9 billion.

Buying investment grade bonds seems sensible because, with the ECB starting its own asset purchases programme next month, the supply will dwindle even further, pushing prices up.

We’ve had asset price inflation for a long time, ever since the Federal Reserve decided to print money more than six years ago. The ECB’s quantitative easing can very well push up consumer price inflation, and quicker than many think.

As oil prices seem to have found a floor, any increase from here on will show up in the figures, contributing to inflationary pressures and lifting inflation expectations.

If that happens, it will be difficult to predict when the wave will crash on land or how high it will be. It may be safe to take advantage of the low tide to look for a safe haven while there’s still time.

Deflation and inflation are scary words – but stagflation is the scariest of all.

@AntoniaOprita

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