James Bevan: Inflation set to remain below target

Fears of a prolonged  period of falling prices in advanced  economies  have eased  over the past few months as  both inflation and inflation expectations  have  rebounded.  Nevertheless, the conditions under which deflation can become entrenched, in particular weak growth and a large degree of spare capacity, persist in Japan and much of Euroland, and this may delay rate hikes globally.

There are a number of reasons why deflation fears have faded since early this year. Global oil prices are no longer falling sharply, which has also helped calm worries that the world was heading  into a major slowdown. Headline inflation in the US, Euroland and the UK is back in positive territory following a brief dip below zero. And longer-term inflation expectations have stabilised.

In the near term, the latest fall in oil prices, from $68pb in May to $57pb today, will push many economies, including  Japan and the UK, back into deflation in the next month or two, which is sure to make headlines, but the bigger picture is that unless oil prices keep falling, headline  inflation will bounce back at the end of this year, as the anniversary of last year’s much bigger declines is reached. The latest drop just means that this rebound will be a little shallower  than previously  expected.

That said, it’s too early to conclude that the inflation risk is over – farm from it. Many OECD economies already have very low core inflation rates and have yet to return to their pre-crisis levels of GDP. In turn, the continued high level of spare capacity in these countries should cause inflation to grind lower and many economies will seek to export deflation with currency devaluation.

In terms of specific countries at risk, Euroland’s heavily indebted southern economies – Greece, Italy, Portugal, and Spain look vulnerable although the latter’s strong growth rate reduces the risks there. Meanwhile, despite Japan’s economy running close to its potential, the gradual tightening in its labour market is unlikely to be sufficient to generate a strong pick-up in wage inflation.

Importantly even if there is not a prolonged bout of deflation, inflation does look set to remain well below central bank targets in a broad range of economies, which will make it hard to put debt ratios on a downward trajectory. For the UK and US we may see slower tightening of money rates than some project, and for Japan and Euroland we should expect an ongoing bias towards further monetary easing.

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

* CCLA is a supporter of Room151.