Will inflation return – or is “Japanification” the real threat?

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Whatever happened to inflation? Many older readers will remember the 1970s, when investors were terrified that stagflation might storm ahead, thrusting us forward towards a Weimar-style hyperinflationary meltdown. And yet, in recent decades, we’ve been worrying about the precise opposite. Specifically, what concerns policy makers and investors these days rather more, is what has happened in Japan.

Ever since its huge financial crash in the late 1980s, the industrial powerhouse has struggled with inflation’s evil twin, deflation. Put simply, Japan has suffered many years where consumer or retail prices have steadily fallen. This sounds benign, but persistent deflation worries economists. They believe that it creates a feedback loop whereby consumers avoid spending today because they think tomorrow everything might become cheaper. As a result, savings grow and demand in the economy slowly crumbles. Combine that with lower-than-average long-term GDP growth, and mix in an ageing society and chronic government overspending (“fiscal deficit”), and we end up with the scenario now described as “Japanification”.

The fear is that it is spreading well beyond Japan. Many argue that this process is already well under way in the eurozone. And while most economists reckon that the US and the UK have so far avoided the process, we can see a direct impact on one key area – interest rates. If inflation is low (and growth weak) central banks such as the Federal Reserve in the US, and the Bank of England, can keep interest rates lower for longer. In the 1970s, with inflation running riot, interest rates regularly pushed past 10%. Now, in the UK, we have a rate of just 0.10%, and many economists believe rates will stay this low for at least another three to five years or possibly many decades.

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How inflation affects asset prices

One could argue that today’s incredibly low rates are an exception prompted by the coronavirus emergency. Once we recover from that shock, a very different situation might emerge. As consumers head back to ravaged high streets, they’ll have less choice and face higher prices. Critics also worry about the massive action taken by central banks to backstop economies during the virus.

A particular concern is that, globally, central banks are printing ever more money to buy yet more bonds and loans. For example, during the 2007-08 financial crisis and subsequent recession, total assets on the Fed’s balance sheet grew sharply from $870bn in August 2007 to $4.5 trillion in early 2015, then declined to under $3.8 trillion. But starting in September 2019, total assets started to rise, and that balance sheet has now expanded to more than $7 trillion.

You don’t have to be a hardcore monetarist to be worried about this huge expansion in central bank balance sheets and the money supply. Many studies have demonstrated a solid positive relationship between long-run inflation and the rate of growth in the money supply. That said, the rate of inflationary increase matters greatly. Most central banks target an inflation rate of around 2%, but wouldn’t be concerned if inflation rose to between 2% and 4%.

As we head above 4%, the real value (ie after inflation) of accumulated government debt begins to slowly depreciate, and there is also some evidence that equities are a decent inflation hedge in the long run. But over shorter time horizons, there is an inverse relationship – rising inflation is associated with falling share prices, and vice versa. And once inflation heads north of 7%, investors in bonds and equities alike start to get much more worried. At that point, “real” physical assets such as property and even gold start to come into their own.

Is inflation really a worry though?

However, there is an important counter-argument. While investors might be worried about the potential for inflation, the hard facts are less alarming. We can get an idea of how much future inflation is priced into financial markets by looking at something called the “breakeven rate” (which in effect, looks at how much future inflation is priced into government bond yields). This currently suggests that 10-year expectations for inflation in the US are sitting around the 1.2% mark or thereabouts.

That’s hardly alarming. Indeed, given the circumstances, many economists still maintain that deflation is the greater risk. They point to subdued measures of wage inflation (made worse by weak union bargaining power), alongside other processes such as globalisation (many products face competitive world markets full of rival producers keen to cut prices), rapid technological change (helping to cut prices of new services) and an ageing society (older investors tend to save more and spend more on non-essential goods frequently missed by inflation measures). Add it all up, and maybe we have more to fear from “Japanification” rather than from a return to 1970s stagflation.

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