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By HaleStewart November 21, 2014 8:34 am
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International Economic Week in Review: Where's the Inflation?

     On the surface, disinflation looks like a great idea.  After all, who wouldn’t like absolute price stability or the possibility of a slight decline in prices?  It sounds like economic nirvana.  However, some level of overall inflation is in fact a good thing because it indicates there is a sufficient level of demand to drive up prices.  Think about it this way.  If a large number of economic participants are doing well they typically want to increase the amount of their purchases.  As more people enter the market they bid on a limited supply of goods, which allows merchants to raise prices.  While too much inflation is obviously of great concern, low levels are healthy.  This explains why most developed economy central banks have an inflation target around 2%.

     However, over the last few years, the potential for global, developed market dis-inflation has moved from a theoretical construct to an actual reality.  Probably the best indicator of this is the global commodity tracking ETF, the DBC:

The above weekly chart shows three years of price moves on the DBC.  Notice the slight but consistent decline from mid-2012 to early 2013.  Prices maintained this level until mid-2014 when they started to drop sharply.  They now stand near three year lows.

     Over the last year, the primary reason for this decline has been the energy sector, as the shown by the DBEs (red line) 18% decline.  But there is also a lack of pressure in the agricultural and industrial metals sectors (black and blue lines, respectively).  Because pricing pressures are muted, precious metals have declined as well (the green line).

     The low inflationary pressure is also very evident in a variety of bond yields.  The above two charts from the Reserve bank of Australia’s chart pack clearly show that nearly across the board, 10-year bond yields are all very low, telling us bond traders see little to no inflation on the horizon in a large number of countries.

     And finally, notice that across much of the developed world, inflation is clearly in check.

     So – why is this happening?

     There are several answers to that question starting with the China slowdown.  While the country is still growing at an impressive 7% Y/O/Y rate, they are trying to “rebalance” their economy, changing the overall growth composition from one based primarily on exports (and, by definition) manufacturing to one based on more balanced sources of growth.  This means that manufacturing has declined in importance, a fact highlighted in the HSBC China manufacturing index:

As China’s raw material appetite has decreased, so has its commodity demand.  Combine this fact with the long lead time for the development of capital projects in the raw material sector; it can take years to open a mining facility.  That means that as China has slowed its consumption, the available sources of raw materials have increased.

     Also consider the weak demand situation in the developed world caused by the soft labor market.

The above graph from an IMF report shows the difference between the pre and post crisis labor markets in the developed world.  The gap is substantial.  As job prospects have dimmed, so has consumer demand, lowering price pressures.  Most importantly, this has occurred at the international level, impacting a number of countries.

     Finally, there is the different nature of the latest recession.  Rather than being caused by a central bank increasing interest rates to slow inflation, the last contraction was caused by the popping of an asset bubble.  On the other side of recovery is an economy whose participants are trying to pay down debt rather than spend money.  That simply slows the pace of the ensuing recovery, which explains why overall GDP growth in most advanced economies has (until recently) been remarkably slow.      

     This is not to say that inflation is contained across the board because we are seeing country level issues.  Russia and Brazil have recently raised rates to combat increasing inflation and India's price pressures are still a potential issue.  But for most of the developed world, inflation is a non-issue right now.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer



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