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Inflation fears: deeply rooted but unjustified

Inflation fears are still surprisingly deeply rooted among private investors. The ‘printing of money’, the rise in government debt and the booming commodity prices are regularly mentioned as risks for higher inflation. This fear is understandable; most investors are old enough to have consciously experienced the inflationary seventies and early eighties, a period which apparently left lasting marks in their DNA.

What many investors do not realise is that in most developed countries those fifteen years represented the ONLY period in which inflation was such a dominant threat. For example, it was the only period in the past two hundred years (!) in which US 10 year treasury yields clearly rose above 6%. The single major economy to deviate from this pattern was Germany, which experienced hyperinflation in the early twenties, causing a trauma which even today helps to explain the strong inflation focus of the Bundesbank and the ECB.

We have to understand that the experience of the seventies was caused by an unusual set of circumstances, unlikely to be repeated. It is virtually impossible to get consistently high inflation without a persistent rise in the main driver of core inflation; wages. The wage/price spiral in the seventies took place in a context of socialistic governments, powerful unions and a young ‘baby booming’ labour force. And the latter did not only have a strong inclination to consume (as youngsters always have), but also a high willingness to strike.

The reality of today is completely different. Unions have lost much of their power, governments are less socialistic and workers much more individualistic. Globalisation has increasingly enforced a Darwinist mindset; survival of the fittest. Pricing power has moved from employees to employers and the latter are firmly in cost cutting mode. And last but not least, the Western economies have a huge overcapacity and an aging population, two phenomena which are inherently deflationary. Fears of a spike in core inflation therefore appear unfounded, certainly in the medium term.

So what about the headline inflation, the inflation including food and energy?

This is a different matter, since the strong growth in emerging markets is likely to push up commodity prices in the long run. But one should not overstate their impact. For example, even when oil prices doubled, like they did in 2007/2008, the effect on headline inflation was limited and not long lasting. After all, one needs these price jumps to occur each year, otherwise their impact fades away in the year over year comparison. Unlike a wage/price spiral, rising commodity prices tend to drive up inflation only for short periods of time.

This leaves the question to what extend a high level of government debt will cause inflation. It has not done so Japan, where a high debt to GDP ratio goes hand in hand with deflation, caused by policy mistakes, an aging society and a high propensity to save. Other developed countries will try to avoid this outcome, even though their own populations now also start to age. They may try to inflate themselves out of their debt by “printing money”, an approach which is not without risk (hyperinflation) itself. Central banks and governments are well aware of this risk, probably more than investors realise. We therefore think that inflation is likely to remain low for long, especially in Europe. So don’t dismiss longer dated government bonds yet, even if their yields appear low. They may be low for a good reason.