Shakespeare may have written the love story to end all love stories, but economists and central bankers alike cannot seem to find the catalyst that will ignite inflation and send the Capulets and Montagues on their merry way to economic prosperity. For the past eight years, countless stimulus packages and quantitative easing programs have hit the ground running, each designed to push the global growth engine into a higher gear, thereby creating as a consequence – now wait for it – inflation. But inflation is nowhere to be found. In fact, commodities have actually deflated, which leaves everyone asking the same question as Juliet many years ago, and that is, “Why?”
We are constantly being told that central bankers focus on a target of 2% for inflation, the goal being that, at such levels, economic activity will respond with GDP growth values of in the 3.0 to 3.5% range, good enough to create an abundance of new jobs, confidence in the populace at large, and overall stability, the primary objectives of any central banker worth his salt. The developed world, however, cannot seem to get out of the 1% gear, no matter how much stimulus is applied. Japan has been trying for over two decades without success. For North America and Europe, these are unfamiliar times. Thankfully, we are not Venezuela, where 500% is the prevailing projection for this year, and the sky is the limit for 2017.
The IMF recently released its annual outlook on the global economy, and its forecast for inflation for developed countries is still abysmal, declining from 1.1% in 2015 down to 1.0% in 2016. The price of oil is cited as the primary driver, but things begin to look up in 2017 when 1.4% is the average for the year to come. In the past, the IMF has tended to err on the optimistic side of the equation, so these figures may be rosier than they should be. The figure below summarizes their take on global inflation projections:
Believe it or not, when you throw in emerging market and developing countries into the mix, the overall average inflation data points begin to approach 3% over the next two years, thereby supporting global GDP growth in the 3.2 to 3.5% range, right where our economic textbooks claimed it would be. Inflation in the emerging and developing sector, with the exception of Venezuela, has been tempered by declining commodity prices, offset by the dissipating effects of falling currency exchange rates. While the developed world lags and sputters along, the rest of the world is not having a joy ride at our expense. Capital outflows and volatility are major issues that have their consequences.
Back to economic basics – Why is moderate inflation of 2% a good thing?
Back in Econ 101, we learned that inflation is “a sustained increase in the general price level of goods and services in an economy over a period of time.” From the chart above, we can ascertain that there has been no “sustained increase” since 2011. Yes, the financial crisis of 2007/08 did jerk the rope, and various attempts by our central bankers to use monetary policy to manipulate market forces did mount a small recovery in the three years that followed. But, according to a vast majority of experts, inflation was supposed to be on steroids, ramping through the roof as money printing presses rolled.
What happened? Excessive expansions of the money supply have always been the root cause for rapid inflation growth rates and even for bouts of hyperinflation, as well. There is one exception in the fine print, however, that most economists seemed to have ignored, and that is the occurrence of what is knows as a “liquidity trap”. If the extra funds are not invested in equipment or infrastructure to create new jobs, but used to pay down debt or hoarded for a rainy day in savings accounts, then the policy changes are ineffective, like pushing on a string, as many economists would say. These conditions have existed for quite a while in Japan, and it seems that this particular malaise has now finally spread to other corridors. Near-zero interest rates are not the answer or solution.
But when and why can moderate inflation be a good thing? There are both positives and negatives. The largest benefit relates to paying down public and private debt over the long haul. Inflation is like a rising tide that produces more cash flow to solve a number of issues. Interest rates would return to nominal levels, thus ensuring that monetary policy changes can be effective to regulate future unemployment and labor cost issues. If inflation is present, then economic activity is churning along with a lower potential for severe adjustments or recessions along the way.
There are downsides, as well. People’s confidence can be dampened, leading to hoarding of both cash and goods for fear they might cost a lot more in a short period of time. Under these circumstances, there is a general reluctance to invest in anything until there is more certainty about future cost dynamics. Hoarding will always create shortages in the supply chain and disrupt market supply and demand forces. If interest rates are near zero, then monetary tools will have little room to do their magic. The money supply has expanded more quickly than economic growth for several years, but inflation has refused to follow. Perhaps, it is time to accept that our actions enabled a liquidity trap to form, and then we fell right into it.
IMF forecasts assume that commodity prices will recover gradually.
The IMF forecasts are predicated on demand for general commodities increasing across the planet over the next two years. Analysts at Wells Fargo have also opined on the current condition as follows: “There are a number of implications of slow global economic growth. First, weak incremental demand for commodities keeps their prices low. Second, slow global growth means that inflation in most economies should remain benign. With global GDP growth and inflation weak, interest rates should remain abnormally low for the foreseeable future.”
With global debt levels reaching a peak, cries for more infrastructure projects and stimulus packages, the general prescription from the IMF and others to get out of the present trap, are falling upon deft ears. If waiting and hoping are to be the game plan, then the accepted bellwether for better days to come will be a ramp up in commodity prices, namely oil. Oil prices have bounced off the mid-twenties and been hovering in the $45/barrel territory for the past few weeks. Will it stay, rise or fall?
In April, the Energy Industry Administration (EIA) also released its updated forecasts for crude oil prices for 2016 and 2017. This group tends to be more conservative than the IMF, and, judging from its take on the current supply glut and production levels at all time highs, it sees the respective price averages for the next two years as coming in at $35 and $41 per barrel, a good bit lower on both counts from today’s valuation. This group enumerates a healthy number of downside risks in the months to come that prevent it from jumping on board with a small group of optimists that foresee a $50 target.
Other analysts have cranked the numbers and believe that if oil stays at $45, there could be a resurgence of inflation, as depicted below:
The U.S. and Canada may be headed for brighter inflationary pastures, but the rest of the developed world will still be laboring to find a 1% year-over-year average increase in domestic price indices. The problem with this scenario is that the Fed will literally be caught between a rock and a hard place, when it comes to adjusting interest rates. If inflation materializes as shown, a rate hike could block the rest of the world from a path of sustained recovery. For this reason, the implied probability in the futures market for either none or one rate hike in 2016 stands today at 86%.
What are the downside risks in these growth forecasts for 2016 and 2017?
The IMF also provides an excellent discussion for each of the issues that it perceives as a downside risk for its projections. They even formularize their forecasted growth rates in what they call a “Probability Fan Chart”. For example, the IMF’s 3.2 to 3.5% GDP growth forecasts fall within a 50% probability range of from 2.7 to 4.3%. They then elaborate on seven distinct areas that could overly influence their projected outcomes:
1) The threat of a disorderly pullback of capital flows and growing risks to financial stability in emerging market economies;
2) The international ramifications of the economic transition in China;
3) Growing strains in countries that are heavily reliant on oil exports;
4) The possible impact of tighter financial conditions and bouts of financial market volatility on confidence and growth if they persist;
5) More protracted recessions in emerging market economies that are currently experiencing distress;
6) Geopolitical risks, and
7) The United Kingdom’s potential exit from the European Union.
The “Net-Net” from the IMF and other forecasting groups is that we are stuck in a long drawn out scenario where nothing will change dramatically in the positive direction, but the downside is also threatening. Probabilities for a recession have been raised for 2016 and 2017, but only slightly. In the U.S., a recession possibility in the coming year has moved from 5% to 20%, a recognition that any bump in the road could dampen whatever confidence exists today and send economic activity into a tailspin.
Inflation, where are you? We need you, and we want you. Our economic futures are depending on you. If growth mirrors what is happening on the inflation front these days, then we might want to revise the IMF forecasts. Their track record is not stellar. In April 2014, they forecasted a 3.9% global GDP growth rate for 2015. The next year, that figure was adjusted downward to 3.5%. The actual was 3.1%.
If we apply the same measure to 2016, then we should expect 3.0%, the same guesstimate made by analysts at Wells Fargo. Maybe they performed the same calculations, but inflation would be below 2% in any event. A recent survey of consumers reveals their expectation for inflation over the next twelve months is 2.6%, but when have consumers ever had a good fix on this data point? Would an inflationary “rose” smell any sweeter, if consumers were correct? Shakespeare never had to worry about such matters, but expect the USD to weaken, as the Fed drags its feet.