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03 Apr 2014

Inflation is too low for comfort

Frederic Neumann

by Frederic Neumann

Co-Head of Asian Economic Research, HSBC

Inflation is too low for comfort

Monetary policy across the world is likely to remain loose for quite some time

Five years after the global financial crisis knocked out growth across much of the developed world, you might think we've finally embarked on a path of steady healing. Unemployment rates are falling, growth is positive, even if a little disappointing, and financial markets, for the most part, exude confidence. But, problems remain: debt, for example, is stubbornly high, and has grown sharply in many emerging markets. Even more troubling: inflation continues to slow across the world, posing renewed risks to financial stability.

In the West, inflation has continued to slow in recent years. Despite unprecedented monetary easing and a gradually tightening labour market, price pressures in the United States have fallen to near multi-decade lows. In the eurozone, inflation is now stuck well below 1 per cent, confounding expectations by the central bank of a gradual acceleration towards its target of close to 2 per cent. Last week, the head of Germany’s central bank, among the most conservative, conceded that more easing may have to be applied to prevent outright deflation.

For decades wealth has accrued faster at the top than at the bottom. Since the rich save proportionately more than they consume, the world is deprived of additional demand

What's new is that even in emerging markets, including Asia, price pressures are tumbling. Take China. Producer prices have already fallen for 24 months. Consumer prices, too, have trended lower, at 2 per cent in February, well below the government’s forecast of 3.5 per cent for this year. Elsewhere, from Korea to Taiwan, and Malaysia to Thailand, inflation also remains muted.

Even in India and Indonesia, given the sharp depreciation of their currencies over the past year, prices have not spiked as much as feared.

The mantra over the last three decades has been that inflation needs to be brought down at all costs. Scarred by the experience of stagflation in the 1970s, central banks applied rigorous inflation targets that often took precedence over other goals like full employment. However, such one-sided obsession ignored the risks that too low inflation, let alone deflation, entails. Especially with debt climbing, falling price pressures can pose challenges to financial stability as credit becomes harder to service.

In emerging Asia, including in China, profit margins among listed firms are at a decade low. The lack of pricing power explains much of this, with excess capacity and lack of global demand forcing firms to lower prices. The cost of traded manufactured goods has fallen since it peaked in 2008, adding pressure to exporters. Domestically, price controls and fierce competition have also added to the pain.

The world needs to heed the experience of Japan with deflation. Once shrugged off as an experience unique to the country, the world is now at risk of stumbling into a similar trap. Falling prices prompted a vicious spiral of falling profits, declining wages, and stagnating prosperity. Japan, however, was lucky in that its wealth allowed it to avoid a bigger calamity, with the government being able to forestall a collapse through continuous pump-priming. Without it, Japan may have seen its economy slide into an outright depression.

What is causing the sudden bout of disinflation across much of the West and in emerging markets? At heart, there is an imbalance between supply and demand. The latter may appear especially puzzling given that interest rates are near record lows and emerging markets are adding an unprecedented number of new consumers to the world economy. Look closely, however, and it becomes quickly apparent that rising income inequality, in both East and West, explains much of the lack of demand.

For decades wealth has accrued faster at the top than at the bottom. Since the rich save proportionately more than they consume, the world is deprived of additional demand. What's more, the growing pool of savings is holding interest rates down and encouraging over-investment. For a while, especially in the West, stagnating wages for the bulk of the population were masked by a boom in household credit, allowing consumers to splurge without a corresponding rise in income. No longer.

In the East, too, there has been a sharp rise in income inequality in recent years. This is often dismissed as an inevitable by-product of rapid economic growth. But that’s not the whole story. The absence of comprehensive social security systems and insufficient income growth among households generally have restrained demand even in Asia. As a result, consumption as a share of GDP has barely risen in most economies while surging investment keeps adding to supply.

That slowing inflation is a growing risk to the world economy is becoming increasingly clear. As a result, monetary policy will remain extraordinarily loose for quite some time. But this, in itself, will not fix the problem. Income needs to be divided more evenly for demand to pick up. This, it should be noted, is not a call for socialist redistribution. But there must be a middle way that allows the gap to narrow over time. If not, the world will drift into deflation, with dire consequences for both rich and poor.

This article originally appeared on the Nikkei Asian Review on 1 April 2014.
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