Global Outlook (November 2016)

From Deflation Risk to Inflation Overshoot

"The fear of global deflation of the past couple of years is fading. Solid growth and higher oil prices mean that a much smaller part of the world is at risk of falling into deflation."

– Richard Jerram, Chief Economist, Bank of Singapore

  • Solid growth and higher oil prices mean that a much smaller part of the world is at risk of falling into deflation. In 2015 nearly 60 per cent of the world economy has inflation below 1 per cent. That proportion will fall to 30 per cent this year and by 2017 will be close to 10 per cent, which is more normal.
  • Central bankers are also more comfortable with the risk of excess inflation rather than deflation. Bank of Japan has committed to expanding liquidity until inflation overshoots its 2 per cent target. More recently, Fed Chair Janet Yellen had suggested allowing the economy to “run hot” in order to repair some of the structural damage caused by the Great Recession. This pro-inflation bias means that interest rates are not raised until well into the recovery.
  • Yet, a slow pace of normalisation does not necessarily mean zero rate hikes. We continue to expect the Fed to push interest rates 0.25 per cent higher at its mid-December meeting, with two more increases in 2017, a comfortably gradual pace of rate increases.
  • In the U.S we are starting to see some evidence of capacity constraints pushing up wages and consumer prices. However, the pace of the pick-up is still quite moderate, which means that the need for Fed tightening is not as urgent, allowing them to move at a fairly gradual pace.
  • Increased government spending is the common theme for both Mr Trump’s and Mrs Clinton’s campaigns. This may imply a faster pace of rate hikes by the Fed as the economy does not have much spare capacity to absorb any material fiscal stimulus. Hence, it would need to be balanced by tighter monetary policy. Such a combination would probably be positive for USD.
  • In Europe, talk of tapering by the European Central Bank (ECB) does not look justified as long as inflation is not making material progress towards the ECB’s target. The ECB is likely to extend its quantitative easing programme at its meeting in December.
  • Growth in the Eurozone seems solid, with composite Purchasing Manager Indices (PMIs) staying over 50, implying expansion, for the past three years, even in the face of a range of geo-political shocks. That resilience will be tested again going into 2017 with a crowded political calendar. Brexit negotiations, the Italian referendum on a new constitution in early December and national elections in France, the Netherlands and Germany in 2017 are inescapable risks in the coming year.
  • For the U.K., the focus on limiting immigration points to a “hard” Brexit and means that trade and investment flows are likely to take a hit. The U.K.’s large current account deficit means that GBP will remain vulnerable.
  • We remain concerned over China’s ballooning credit-to-GDP ratio despite efforts aimed at deleveraging. Rapid lending, high investment rates and slowing growth are a combination that suggests an inefficient allocation of credit and an eventual bad debt crisis. In China the process is largely internal – so no Lehman shock – and dominated by the state. Consequently, this implies that China’s growth rate should grind much lower should the credit bubble pop.
  • In Japan, the relentless grind of demographics means that growth has likely settled around its potential at 0-1 per cent, with fluctuations driven by fiscal policy or swings in the exchange rate. The emphasis needs to be on structural reform to raise the potential growth rate. Unfortunately, it is hard to find much evidence of progress, despite the government’s dominance of both houses of parliament.
  • Adjustments in Emerging Markets (EM) in the last few years in reaction to slower Chinese demand, lower commodity prices and the taper tantrum have improved growth prospects especially in countries like Argentina, Brazil, Indonesia, Mexico and Russia. This should help resilience if the U.S. implements two or three rate hikes in 2017, as we expect.
  • Asia still looks solid in the face of sluggish growth in the developed world and troubles in China. Low inflation and (mostly) solid government finances give policy flexibility if needed