• Concerns. The palpable recovery of the global economy, in conjunction with skyrocketing government debt and ballooning central bank balance sheets as a visible sign of the massive injection of liquidity, is fueling fears among investors of a (later) resurgence of inflation. The argument here is that governments want to unload debt “without paying the piper”.

  • Confidence. We, however, do not share this view. While headline inflation will almost certainly move out of negative territory and accelerate strongly given the negative base effect of the oil price, it will nevertheless remain consistent with central bank targets. And the more important – because it is less volatile – core inflation will continue to moderate well into next year. There is therefore no reason for haste to tighten.

  • Central banks. First, we argue that independent central banks will be able to resist political pressure or allow higher inflation. That applies primarily to the ECB. Second, they also have the instruments at their disposal to siphon the excess liquidity out of the system in a timely manner (pages 8-9). On top of that, there are cyclical reasons.

  • Economic slack. Since the recovery is not sustainable at its current pace, the decline in the underutilization of the production factors capital and labor will be only gradual as indicated by this week' s FOMC statement. The output gap is by no means closing, and labor cost pressure is easing even further.

  • Forecasts. For that reason, core inflation will continue to trend south. In the US, it will slow to ½% or even lower by the middle of next year, especially since there is also relief from falling import prices (pages 3-5). In the euro zone, core CPI will even approach the zero line at the end of 2010 (pages 6-7). Hence, there is no reason for central banks for haste, even if inflation concerns may flare up again from time to time.

  • Further topics:

    – Weekly Comment: Who’s afraid of the inflation wolf (page 2)?

    – Germany: Election outcome is anyone’s guess (page 10).

    – Data outlook: Economic climate to improve further (page 14).

    – Market outlook: Bonds maintained, EUR still in demand (page 23).


Who is afraid of the inflation wolf?

Investors’ views on inflation remain polarized, with many comfortable with the idea that inflation pressures are unlikely to emerge within the investment-relevant horizon, and others already seriously concerned that a surge in inflation down the road is inevitable. By contrast, policymakers are almost unanimous in reassuring markets and consumers that inflation will remain under control – even Axel Weber, the Bundesbank’s President with unquestionable anti-inflation credentials, has recently voiced a similar sanguine view. This is at least the second notable dissonance between policymakers and investors, the biggest one being marked by the enthusiastic recovery in equity markets against the background of sober official exhortations to prudence and caution. UniCredit’s house view, as you know, is that inflation is not a realistic concern over at least an 18-month horizon. Our line of argument has been well developed and articulated in our publications, and you will find an update by Harm Bandholz and Marco Valli in this edition of the Friday Notes. The opposite view is built upon two complementary sets of considerations, one fiscal, one monetary. On the fiscal side, the concern arises from the sizable expansion in fiscal imbalances triggered by the crisis. Government debt levels are rising markedly in many countries, reflecting both the cyclical deterioration in fiscal accounts due to the recession and the direct interventions to support the financial system, with some governments assuming at one go a large stock of banking sector liabilities. The fear is that policymakers will then be tempted to resort to somewhat higher inflation to erode the real value of their debt, as an attractive alternative to a draconian fiscal adjustment.

I find this line of reasoning unconvincing for several reasons. First of all, in many developed countries, the guardians of inflation are fiercely independent central banks, which seem extremely unlikely to bow to political pressure or allow higher inflation. Indeed, it was exactly the abundant academic literature on the danger of politically-motivated inflation and time consistency and rules vs. discretion issues (Kydland and Prescott 1977, Barro and Gordon 1982 and subsequent contributions) that contributed to the push towards independent central banks and inflation targeting. In the case of the euro zone, nowadays it seems really far-fetched to think that the ECB would bend to governments’ desires and consciously allow above-target inflation. Admittedly, it is somewhat easier to consider such a scenario for countries like the UK, where central bank independence is not as strongly entrenched, or the US, where the Fed’s balance of risk tolerance is a bit more tilted towards flirting with higher inflation than with lower growth. But even there, one has to wonder to what extent governments would really discount the political risks of inflation, which erodes purchasing power with a tremendously regressive effect in terms of income distribution. Again, the euro zone provides an example in this regard: ECB President Trichet has been tireless in reminding us that low and stable inflation is a crucial support for income, and that the central bank’s anti-inflation stance is therefore in the best interest of citizens and voters. And given how unpopular inflation is in Germany, for the largest ECB shareholder it would be political suicide to push for higher inflation. Finally, note that, to consciously push for somewhat higher inflation, policymakers would need to feel comfortable that the rise in inflation can be controlled and fine-tuned. Given the brutal and unpredictable nature of swings in macroeconomic and financial variables that we have experienced over the last few years, this would be a foolhardy assumption indeed. The second type of concern seems more plausible. The argument here is that there is still an enormous amount of liquidity in financial markets, some of it of course injected by central banks, and a lot of it frozen by the terror induced by the financial crisis. As financial markets begin to thaw out – the argument goes – this large amount of liquidity could suddenly flood the global financial system and the real economy, and part of it would almost certainly spill over into consumer price inflation, especially if it comes online while fiscal policy is still strongly expansionary. This argument, as I said, rings more plausible. We know for a fact that major central banks have expanded their balance sheets to an unprecedented level and previously unthought of proportion. And as we have seen how the last credit bubble translated into unstoppable asset price inflation, it is hard to discount the risk that a new bubble might quickly materialize. Indeed, we have already had a debate on a possible government debt bubble, as rising supply fails to trigger a significant rise in yields, and there are strong suspicions that the latest rise in stock prices might reflect largely the impact of yield-hunting liquidity rather than brighter economic prospects. Here, though, it is important to keep things in perspective. I do believe that excess liquidity might trigger small-scale asset bubbles along the way. But consumer prices will not accelerate against a background of rising unemployment and large unutilized capacity – which is the outlook we face over the coming 12-15 months.

Bottomline: we should not worry about inflation until we can start worrying about whether growth is accelerating too fast. For the time being, the resilience and sustainable pace of growth remain the greater doubts, and the ability of policymakers to finetune the exit strategies from stimulus and to put in place measures to guarantee fiscal sustainability will be extremely important. On this front, probably the most important event on the euro-zone’s calendar is the German election on Sunday, which Alexander Koch discusses in a very interesting research note in this issue.