Never mind the output gap

January 20, 2010

The inflation vs. deflation debate has livened up again following the jump in December’s UK consumer price inflation (CPI) to 2.9 percent. Last year you couldn’t move for economists harping on about the output gap and blithely dismissing arguments about imported inflation, rising commodity prices, and oh yes, the little matter of the money supply.

Indian inflation

Simon Ward, chief economist at Henderson Global Investors, takes the threat of inflation more seriously. He points out that the big swings in inflation in recent years have been driven by food and energy prices, and the latter are beginning to rebound sharply.

“Many economists believe inflation will stay low due to the industrial output gap, but even that has been picking up,” he adds. The seven leading emerging markets, which together account for 71 percent of combined world GDP growth, are back at normal levels of capacity usage, and will soon move above these.

Commodity prices are also recovering strongly on the back of emerging market industrial output, and Ward suggests this could drive up headline inflation. Indian manufactured good prices were up 4 percent in December, year-on-year, a sign that inflation pressures are spreading from food prices to the broader economy.

Ward now sees UK headline inflation at 4-5 percent by spring and 3 percent or more for the G7 as a whole. As a result, central banks will be forced to raise interest rates earlier than they would like, and than the markets anticipate.

“There is a danger that emerging market economies will overheat before the G7 economies have fully recovered, and the inflation will necessitate tightening,” he said.

Any tightening is likely to hit both bonds and equities, with bonds bearing the brunt of the damage. Although buying by insurers and pensions funds will provide some support to government bonds, demand from banks will not be enough to offset the withdrawal of the Bank of England from the market, he said.

On a medium term basis, he was more optimistic about equities, however. “Equities may see a nasty correction at some point in 2010 but they will still make progress,” Ward said.

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