Most portfolio managers don’t consider inflation a threat in the industrialized world right now. But inflation isn’t dead, and fears that it will rise again could play havoc with U.S. monetary policy. At the same time, Europe continues to flirt with deflation, which could exacerbate the fiscal and debt problems in that region.
There currently is too much excess capacity – idle plant and equipment – to allow companies to raise prices. And unemployment is too high for workers to demand wage increases.
This will continue to be the case until the North American and European output gaps – the difference between what these countries could be producing and what they are producing – are closed.
Nevertheless, U.S. economic growth is increasing and financial markets will be carefully monitoring the consumer price index (CPI) for any signs of increasing inflation. If inflation expectations rise, the markets could lose faith in the ability of the U.S. Federal Reserve Board to close its quantitative easing program – purchases of government bonds – and still control inflation. If that happens, long-term interest rates would rise, which could push the U.S. economy back into recession.
“The U.S. can’t currently withstand 10-year Treasury rates of 4%,” says Stéphane Marion, chief economist and strategist at National Bank of Canada in Montreal. Other portfolio managers agree, assuming, as does Marion, that long rates will end this year at around 3.25%-3.5% vs 3.03% on Dec. 31, 2013.
The problem in Europe is that excess capacity and high unemployment could force companies to lower their prices. This scenario is already unfolding in Greece, where the CPI was down by 2% in October from a year earlier. There also were marginal declines in CPI of 0.2% in Portugal, 0.1% in Spain and, surprisingly, 0.3% in Switzerland, the last of which is still a relatively strong economy.
The eurozone as a whole had an average 0.7% increase in CPI – which sounds fine on its own, but the rate of increase has moved down sharply from 2.5% a year earlier. Prices in the region declined in October and in four of the previous 11 months.
Marion considers this scenario a major risk, although he assumes the European Central Bank will be able to prevent excess inflation by aggressively pumping liquidity into the financial system.
Inflation is still a threat in emerging countries, where governments have to be vigilant to keep the price pressure from strong growth and rising wages under control. But food prices are declining and energy and base metal prices are expected to remain around current levels or drop a little, so the risk of significantly higher inflation in those countries is low.
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