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Diving Inflation, Deeper Malaise?

Updated: May 19, 2022

Equity markets should be encouraged by Bank of England Governor Mark Carney's optimism that inflation will at some point start to rise back towards the central bank's 2% target. However, investors must remain vigilant to the possibility that he is wrong and that his downside risk scenario of entrenched deflation actually materializes.

Deflation, once it becomes entrenched, can have horrible consequences, particularly for investors. Since interest rates can't go negative if they did we'd all pull our money out from the bank deflation means higher real interest rates and thus even more downward pressure on growth and prices. Secondly, since debts are generally fixed in nominal terms, deflation means the value of the debt goes up in real terms. Finally, if deflation becomes entrenched, consumers begin to postpone purchases knowing that prices will be lower next month.

These three factors are bad for growth and thus bad for equity markets. Why is Carney so relaxed?

Inflation is running close to zero and will remain there he says for much of this year, possibly even turning negative in the spring. Surely it would not take much for expectations of falling prices to take hold,


Wrong, says Carney. He points to core inflation that, while below the Bank's inflation target of 2%, is still well above zero. Furthermore, he says that the fall in the oil price and the monetary stimulus announced recently by the ECB will combine to support growth here in the UK and that in due course headline inflation will begin to head back towards the 2% target.

The good news for investors is that even if there are signs that the oil price fall, what one can think of as good deflation, is turning into something nastier, the Bank of England has the tools to act and ability to use them. As Carney said, the Bank is "vigilant to the risks of disappointing global growth or any signs that low inflation begins to affect inflation expectations and wage growth, and therefore becomes self-reinforcing. Were these downside risks to materialise, the Committee could adjust the pace and degree of Bank Rate increases, expand the Asset Purchase Facility, or cut Bank Rate further towards zero.

My concern is not so much that Carney is wrong I agree that the oil price fall and ECB stimulus should add support to growth in the short term but that the very low inflation everywhere you look, from the UK, to Europe, to China is a sign of some deeper malaise. Economic growth is a function of population growth and productivity growth.

It may also be a function of debt, though such a notion is rejected by classical economics, which instead says that because every debt has a credit and thus nets to zero, it doesn't matter how much of it there is. This notwithstanding, population growth around the world is falling. Japan is on the frontline of this battle; it is estimated that its population could fall from 127 million to 87 million by 2060.

Productivity growth around the world is also falling. While the steam engine and the internal combustion engine had dramatic and long-lasting effects on productivity, the combined impact of the silicon chip and the Internet has been small by comparison and has largely run its course.

And despite what classical economics has to say or not say about debt, it does matter.

In his seminal 2002 speech, former Federal Reserve Governor Ben Bernanke warned that while deflation and zero nominal interest rates "create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation".

A recent report by McKinsey found that "Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points." While central banks around the world may succeed in avoiding deflation this time round, there is no guarantee that at some point they will simply run out of ammunition or suffocate under the weight of debt.

Published in Professional Investor

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