Developed world core inflation has likely peaked

After rising for most of the last 18 months, core inflation rates have stabilized of late and are now likely to dip lower. The rise in inflation until recently had been one reason some of the major developed world central banks (the ECB in particular) were reluctant to ease. This has now likely changed, as pressures for inflation are now turning negative and none of the major central banks expects inflation to rise over the
next 6 to 12 months. While the effectiveness of easing with rates at or close to zero remains a question, inflation is increasingly less likely to be a reason to keep central banks from trying to ease if growth conditions warrant it.

Most of the reasons why inflation rose since early 2010 are reversing, though the effects may take some time to flow through. Cyclical conditions have gone from extremely disinflationary in 2009 to less so. However, the recent slowing of developed world growth should once again be a negative for core inflation. The commodity price increases flowing to core should also gradually fade as long as commodity prices remain roughly stable. Likewise, strong emerging market economies and currencies contributed to rising inflation rates in the developed world in recent years, but currency declines and slower recent growth rates will ease those pressures.

Core inflation rates have recently stabilized at roughly where inflation has averaged for the last 10 years, and short-term inflation expectations are pricing rough stability in inflation in the near term. We think that near-term inflation rates are more likely to decline modestly than to increase.

Central banks differ in how much weight they give to recent inflation relative to growth and levels of activity as well as forward-looking inflation expectations. Some central banks, like the ECB, had been pointing to higher inflation as a major reason for tighter monetary policy (they actually tightened midyear). However, even the ECB has recently recognized that inflation has peaked and pressures on inflation have
turned lower.

Recent Central Bank Comments on Inflation

The market pricing is also consistent with benign inflation rates, both in the short term and long term. The
pricing is relatively flat for the next 10 years, rising from about 1.5% to about 1.7%.

In terms of changes, market expectations for inflation have been declining for about three months now.

While it makes sense that the recent deterioration in conditions should lead to lower inflation in the short term, it is interesting that long-term inflation expectations have also been declining over this period. Falling long-term inflation expectations are to a significant extent a function of expectations for policy over time, and the current market action suggests that the perceived risks of inadequate or
ineffective stimulation have increased relative to concerns over printing.

Meanwhile there is much confusion about whether Quantitative Easing (QE) has ‘worked’ because there is much confusion about what it is actually for. For the UK, the Bank of England typically inflates money supply via money market operations (MMO) with the commercial banks. However, when those same banks are shedding risk assets (loans), money supply growth goes into reverse. QE is a debt market operation (DMO) with non-bank counterparties, which directly boosts their cash holdings, which then become bank deposit liabilities, or money supply. We can estimate that without QE, money supply would have shrunk by roughly 13% and the UK would already be in outright textbook deflation; indeed, by some measures, and in spite of a CPI at 5.2%, the UK is already deflating.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla