Thursday, June 18, 2009


Medium-term inflation risks – how much of a threat are they?

Rarely has the inflation outlook given rise to such differences in opinion as today. While some experts – including the OECD – warn against deflation, others believe inflation will accelerate strongly in the medium run.

To be sure, monetary and fiscal policies are currently moving in unknown territory so – of course – caution is advised in the analysis. However, we consider worries about inflation to be exaggerated, even on a 3 to 5-year horizon.

Such worries have been triggered by the huge expansion in central bank balance sheets. But this does not automatically lead to a surge in the money supply, as recent data on money supply growth in the euro area has shown.

When the credit multiplier returns to normal, both the Fed and the ECB will scale back their open-market operations to mop up liquidity. The same holds for fiscal policy with the current attempts to at least partly offset the slump in private-sector demand. Scenarios for reducing the massive budget deficits are already being developed both in the US and in Brussels, to be
implemented once business activity picks up again.

Permanent monetisation of public-sector debt by the central banks or its reduction via higher inflation are unlikely on account of the following structural changes:
— Independent central banks which safeguard the efforts expended on anchoring inflation expectations at a low level.

— The increasing role of international capital markets that are needed for the seamless refinancing of public-sector debt (around one-seventh per year). In addition, the vast majority of new issuance is acquired by institutional investors that react extremely quickly to changes in the inflation outlook. Higher inflation and thus rising interest rates therefore do not represent an attractive option for governments.

— The low money illusion of households that reduces the opportunity for policymakers to levy a stealth “inflation tax”.

— The growing inflation aversion of ageing societies with large financial wealth and on average fewer opportunities to save more to offset the depreciation of their assets caused by rising inflation.

— As much as 38% of outstanding US Treasuries are held by the US social security system. Since pension insurance payments are index-linked, higher inflation would cause huge problems.

In light of the deep recession and dramatic capacity underutilisation, inflation looks set to remain extremely moderate in 2009 and 2010 – in some cases price levels will fall – and not exceed 2-3% p.a. in the larger industrial countries over the medium term.

To see full report: INFLATION