No Inflation Threat In 2013

Central banks may have become more tolerant of inflation, but that does not mean that there will be higher inflation rates in the next year.

No Inflation Threat In 2013 O n the surface, policy settings around the world look very inflationary with large fiscal deficits and aggressively easy monetary policies. Yet, it is hard to see inflation gaining any traction when global activity is so weak and the monetary transmission process is impaired in many countries. Global traded goods prices are falling, wages are growing very slowly in the major economies and monetary growth is moderate. There is more of a deflationary than inflationary tone to the economic environment and it does not look as if this will change any time soon.

Central bankers have definitely softened their attitude to inflation and are prepared to take risks in the direction of higher prices in order to ensure a faster pace of growth. However, once economic growth does move on to sounder foundations, then policymakers’ attitudes will harden.

In other words, faster economic growth is a pre-condition for a sustained major inflation problem, but an improved economy will trigger a tightening in policy. It would be a mistake to think that the current generation of central bankers believes that sustained high inflation would be a desirable solution to current debt levels.

Bottom Line: Inflation will remain broadly benign in 2013.

The Sustainability Of Government Debt

Rising U.S. debt levels ultimately will prove to be unsustainable, so the only uncertainty is the timing of when the markets will force a change. The problem may not yet be acute, but it will become so within the next five years.

The Sustainability Of Government Debt T he sustainability of government debt depends on the size of the primary deficit and the gap between nominal GDP growth and borrowing costs. In the case of the U.S., GDP growth has been above interest costs, but the debt-to-GDP ratio has been rising because the primary deficit has been so large. Italy also has rising debt burdens, but for the opposite reasons: the primary balance is in large surplus but interest costs are far above nominal GDP growth. Japan has the worst of both worlds: a large primary deficit and rates modestly above GDP growth, while Germany has the reverse: a primary surplus and growth above interest costs.

The IMF provides estimates the fiscal adjustments that various countries will need in order to bring debt-to-GDP ratios back to 60% by 2030. The U.S. needs far more adjustment than the peripheral euro area countries that currently are being punished by the markets and only Japan is in a worse position. Indeed, the adjustment needed in the U.S. is more than twice the size of the fiscal cliff that currently is causing so much consternation.

Thus far, the markets have been remarkably tolerant of large U.S. fiscal deficits, and Japan has been able to live for years with massive deficits and a debt-to-GDP ratio above 100%. A world of moderate economic growth, rising private sector savings, risk-averse investors, and zero short-term interest rates has kept the bond vigilantes at bay. These conditions can last for quite a while longer, so a market riot point may be inevitable, but is nonetheless not imminent.

Stay tuned.