Markets spooked by inflation spectre

President Clinton's election victory was based on the motto, 'The economy, stupid'. I have always believed that the behaviour of the world's financial markets could be best understood with an even more terse motto - 'Inflation, stupid'.

Provided that inflation pressures are falling, interest rates will be in decline. And since virtually every asset price depends either directly or indirectly on discounting future earnings flows by expected interest rates, this should be sufficient - or almost sufficient - to guarantee strong asset market performance.

The one caveat, and therefore the reason for the 'almost' in the last sentence, is that equities and property could for a time perform badly if inflation were improving because of a slump in activity that made the market permanently more pessimistic about the outlook for profits. But even then the powerful effect of declining interest rates is usually enough to ensure strong equity performance in disinflationary conditions.

I make these points despite the fact that they appear to have been contradicted by the anaemic (or just downright bad) behaviour of the markets so far this year. This has happened in the face of the best performance on global inflation for decades, and also in defiance of further monetary easing by most of the main central banks (though with the obvious exception of the US Federal Reserve).

The European central banks in particular must be getting exasperated about the behaviour of the bond markets. Not one of the central banks has uttered a word of warning about interest rates needing to rise; in fact, they can rarely have mounted a more concerted effort to persuade the markets that short-term rates will stay low, or decline further.

SHADOW OF 1970s

Despite this, the forward markets throughout Europe are now indicating that short rates are at or near their trough, with a sizeable increase in rates now being expected during 1995. This is very bad news for the authorities, since it means that the markets are autonomously tightening monetary conditions despite the fact that the central banks genuinely believe this to be entirely inappropriate.

It is hard to explain why the markets are so jumpy about inflation at present. One factor, though, is that the unhappy experiences of the 1970s continue to cast a long shadow. Then, the markets refused to believe that the monetary authorities would lose control over inflation as comprehensively as they did, so they accepted yields on government debt that failed to compensate them for rising prices for many years in succession.

This period of daylight robbery has left the legacy that the markets now require a high and permanent risk premium just in case inflation takes off again. With global activity now beginning to rise quite strongly - the Anglo-Saxon economies are booming, Continental Europe is limping past the trough, and Japan is beginning to flatten out - markets appear paranoid about inflation.

Just because you are paranoid, as the saying goes, it does not mean they are not out to get you. But right now it seems hard to justify inflation paranoia on virtually any level. Consider the following key points.

First, global inflation has never risen for any length of time when there is a sizeable gap between actual output and potential output in the developed economies. Taking the developed economies as a block, the recent recession was not particularly sharp in any given year, mainly because it was de- synchronised between continents.

However, because the recession dragged on a long time, while potential output continued to grow, a large output gap developed. For the G7 economies, this now stands at about 3 per cent, and it is likely to rise fractionally this year and next.

Last time this happened, in the early 1980s, global inflation fell by more than 2 percentage points a year. This time, inflation has fallen much more slowly, mainly because price rises become much more sticky when the running rate for inflation is already so low. But for inflation to stop declining when the output gap is so wide, and actually tending to rise further, would be quite unprecedented.

The second key point is that this output gap is, naturally enough, accompanied by more slack in the labour markets than at any time for several decades. Even in the Anglo-Saxon economies, which have now been recovering for several years, there are as yet few indications that labour costs have bottomed out.

Unemployment is at post-war highs in the developed world, and survey indicators suggest that labour shortgages are non-existent in virtually every economy. Even allowing for the fact that the 'market clearing' unemployment rate seems to rise over time, especially in Europe, labour market pressures are conspicuous by their total absence.

If inflation were to rise in current conditions, it could only be because of a huge shock to commodity prices. A small or medium- sized shock would not be enough, because commodities are of much less importance to our increasingly service-oriented economies than they used to be.

The US financial markets from time to time get themselves worked up about supposed surges in commodity prices. But quite often this is for the ludicrous reason that they monitor the gold price as an inflation lead indicator. On other occasions, it is for the slightly less ludicrous reason that they focus on a commodity index called the 'CRB' index.

BIZARRE WEIGHTING

This index gives equal weights to all primary commodities, whatever their importance in the production process. As a result of the bizarre structure of this index, orange juice futures are as likely to scare the bond markets as crude oil futures.

But if we instead examine a commodity index that is weighted according to the importance of each item for world inflation - such as the Goldman Sachs index - we find that prices are now at all-time lows relative to consumer goods prices. Furthermore, despite the occasional scare, this index has dropped by 11 per cent in the last 12 months.

Commodity prices may indeed rise a little in the next couple of years, reflecting strong demand for basic goods from emerging economies, but it would take an explosion of most improbable proportions to cause more than a blip in global consumer prices.

Finally, what about monetary growth? With the exception of Germany, where the Bundesbank has been scratching its head about stubbornly high broad money growth, there are few signs of any looming problems. In fact, for the seven biggest economies, broad money growth has lagged behind national income growth for some years, and this seems to be continuing.

It is therefore almost impossible to make a sensible case for rising inflation in the developed economies in the next couple of years from virtually any angle. At present, the running rate for inflation in the OECD area is no higher than 2 per cent, the lowest rate since the war.

Allowing for improvements in the quality of goods which do not get accurately recorded in price indices (a car today, for example, is a very different product from a car two decades ago), this is very close to genuine price stability throughout the developed world.

There is no reason for the central banks to wish, even in their wildest dreams, to depress inflation any further. And no reason either for the financial markets to continue to see inflationary spooks round every corner.

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