Will all this lead to inflation or deflation? As the debate rages among economists, the markets seem to be adopting an intermediate position. The long-term expectations of market participants, as reflected by the market for inflation-linked bonds, remain moderate: 2% in the United States, 2.3% in Canada and Australia, 2.4% in the eurozone, and 1.1% in Japan. Even expectations of 6% in South Africa and Brazil remain well below the pre-crisis levels. Meanwhile, we feel that the rise in the price of gold seems more a reflection on skepticism toward the dollar and near-zero short-term interest rates than a reflection of actual inflationary fears. Moreover, over the long term, gold has proven to be a rather poor hedge against inflation.

 

A recent study published by the Federal Reserve of San Francisco sheds some interesting light on the debate. If the economic consensus today is counting on an inflation rate of 1.9% for the US in 2010 – largely in positive territory – then measuring the standard deviation of these forecasts shows that the level of anxiety regarding inflation differs greatly depending on the time horizon. The downside risks related to the sharp rise in unemployment and underutilization of production capacity seem to be driving short-term concerns, while the possibility that the massive creation of cash by central banks will lead to inflation is essentially perceived to be a long-term risk.

 

We agree with the conclusions of the study. The exceptional measures taken to fight the crisis are clearly reflationary, and their positive effects are starting to become apparent. Signs of an upturn in economic activity and a return of confidence on the financial markets have been multiplying for several months now, in the United States, in Europe, and in Asia. While the determined actions of economic policymakers have helped avoid a total-disaster situation, major concerns remain as to the sustainability of the recovery once the effects these actions wear off. Without a pick-up in consumer spending or capital expenditures by companies, the recovery could turn out to be short lived. On the other hand, a relapse in business activity after the effects of the recovery plans have faded would mean insufficient growth for new job creation and for using surplus production capacity, thus reinforcing disinflationary tendencies and possibly even going so far as to bring about the onset of deflation.

 

Without a doubt, the substantial volume of liquidity injected in the financial system and the temptation to try to monetize the increase in public debt do constitute significant long-term inflationary risks. Nevertheless, in our opinion it is not very likely that these risks will materialize as long as there is no sign that this abundance of cash is being transferred from the banks to other economic players. As the possibility of further significant deleveraging remains, we think it would be wrong to expect a quick recovery of the credit creation process.

 

Without minimizing the long-term risk of inflation, deflationary trends will continue to dominate in the short term. Despite encouraging signs, central banks and governments could still tip the debate toward the deflation camp by incorrectly assessing the situation and tightening their monetary and fiscal policies prematurely. Patience and some tolerance toward an increase in inflationary expectations and public debt seem to be the price that must be paid to definitively avoid the worst excesses of the crisis – with the unfortunate risk being that the measures taken today might end up creating a great deal of cyclical instability in the future.

 

Stéphane Monier, Head of Fixed Income and Currencies