At Long Last, Inflation

By: Jens Erik Gould

Published: May 12, 2014

For the past two and a half years, inflation in the developed world has been the
bogeyman that never shows his face. Growth in consumer prices has done nothing
but decelerate, even as economic growth prospects have improved. Whether that is
good or bad is debatable. On one hand, it has made it easier for the U.S. Federal
Reserve to justify loose monetary policy aimed at strengthening the economic
recovery. On the other, its fueled investor concern over Europe, where the specter
of actual deflation complicates the future value of debt repayments and has raised
concerns about future growth.

In any case, the issue may soon be moot, as inflation is set to stage a long-awaited
comeback, according to Credit Suisses April 25 report Inflation: The Noise is the
Signal. In the U.S., an improving labor market will start to stimulate inflation,
according to Fed Chair Janet Yellen. She also thinks that factors currently keeping
consumer prices down, such as a deceleration in energy cost growth, wont last. The
Fed therefore expects inflation to return to the banks 2 percent target in 2015 after
nearly two years of falling beneath it. To some extent, the low rate of inflation seems
due to influences that are likely to be temporary, Yellen said in an April 16 speech.
Longer-run inflation expectations have remained remarkably steady, however.

In Europe, a continuing, albeit slow, economic recovery is expected to push prices
up as well. While GDP growth rates forecasted by the European Commission1.2
percent this year and 1.7 percent next are modest enough, theyre nevertheless a
definite improvement over the continents deep recession of 2011 and 2012. And the
Commissions forecast of 0.8 percent inflation this year and 1.2 percent next year
should put concerns about deflation and disinflation on the backburner. According
to preliminary data, annual inflation was 0.7 percent in the euro zone in April, more
than the 0.5 percent reading in March and just under Credit Suisses forecast of 0.8
percent. Finally, Japan appears on a path to perhaps finally shake off its dogged
deflation. Its central bank said last week that inflation will exceed 2 percent in fiscal
year 2016.

Forthcoming April data, says Credit Suisse, will likely show that the turnaround in
consumer prices has already begun, with core inflation on the rise in all of the U.S.,
Europe and Japan. Japan, in fact, is expected to show its largest monthly increase in
the last 15 years, driven by an increase in the consumption tax rate from 5 to 8
percent on April 1, which led core consumer inflation in Tokyo to jump to a 22-year
high. In the U.S., the year-on-year April figure is expected to jump due to last years
reduction in Medicare payments tied to federal budget cuts. European prices should
actually fall in May relative to April because of the unusual timing of Easter last year.

While that kind of volatility might normally suggest more hawkish monetary policy, its
driven largely by seasonal factors and recent policy changes, which will make the
seeming acceleration short-lived. That, along with the fact that the economic
recovery is still weak, means markets are still not expecting the first Fed rate hike
until mid- to late-2015. For now, the markets implied path of when hikes begin, how
quickly rates rise, and where terminal rates will be remains reasonably close to the
Feds guidance, analysts Axel Lang and James Sweeney say in the Credit Suisse
report.

But that scenario wont last forever. Markets will become increasingly sensitive as
soon as inflation reverses course for good later this year, the job outlook continues to
strengthen, and the Fed further reduces its asset purchases, according to Credit
Suisse. At that point, investors will view the Feds forward guidance as less relevant,
and will take on more varied views about the path of inflation. Consequently, Lang
and Sweeney conclude, the volatility in the rates market will come back in [a] more
permanent fashion.