Live Support Centre

Forex News

Inflated Opinions

Posted on: 27 September 2017 , by: Darren Sinden , category: Market Review

Estimated Reading Time: 6 minutes

Inflated Opinions - Weekly Analyst Insight by Darren Sinden

A look at why inflation is a scarce commodity in developed economies and what that means for central bank policy and FX traders. 

Boom and bust: What went before

For much of the 20th century, the world's economies swung between periods of prosperity and growth known colloquially as "Booms" and periods of contraction and austerity known as "Busts". These pendulum swings in economic progress occurred frequently. 

Studies from the US National Bureau of Economic Research shows there have been 28 of these swings from boom to bust (14 per side) in the American economy between 1929 and 2009. Over this time frame large changes in inflation accompanied periods of economic growth. Those changes  (which economist’s view as excess demand) were often the cause of subsequent downturns or recessions.

Central bankers, governments, businesses and the markets, were all keen to smooth out the peaks and troughs, to control the inflationary ogre once and for all. Various techniques were suggested. Most of which proved to be ineffective. However, it was believed in “the noughties” (incorrectly as it turned out) that the developed markets had removed cyclicality from their economies through the globalisation of trade and coordination in central bank policy.

But as we found out in 2007/8, all that happened was that cyclicality shifted away from industry and into financial services. The recession that followed in 2009 was as painful as those felt in the old economies of the 1970s. But unlike previous recessions, the spectre of inflation did not rear its head. Inflation was absent from the field entirely, instead, it's dangerous alter ego deflation made a very unwelcome appearance.

New millennium boom and crash

The cause of the 2007/8 Global Financial Crisis was excessive leverage amongst financial institutions, both on their balance sheets and in the instruments they sold. Many were guilty of classic bubble behaviour that is trading or investing in riskier and riskier investments. While expecting them to perform just like the docile investments that they were trading at the beginning of that cycle back in December 2001. 

By 2007 people without jobs or regular income could get a mortgage. Those mortgages were collectively repackaged by the investment banks and sold on to their institutional customers as complex, but potentially lucrative securities. In what amounted to a financial version of the emperor's new clothes, many of these exotic securities were placed in investment vehicles which relied on short-term funding, to meet longer-term commitments. It was in these short-term markets that the GFC began. Credit dried up and then disappeared altogether. What happened next is now part of history. As noted above, when the 2009 recession developed deflation rather than inflation reared its ugly head.

But just what is deflation?

It's the polar opposite of inflation. Whereas inflation is characterised as an excess of demand or, chasing a limited supply of goods and services. Deflation occurs when an excess of supply ends up chasing limited demand. Under inflationary conditions prices rise and consumers tend to stock up on goods, in the expectation of yet higher prices in future. However under deflation consumers defer purchases, in the belief that goods and services will be cheaper tomorrow. Deferred consumption causes levels of demand to fall further exacerbating the deflationary spiral. 

Fear of an embedded deflationary spiral caused central banks to cut interest rates and deploy quantitative easing. They nominated inflation targets of 2% as they did so. But even that lowly hurdle would turn out to be very difficult to attain. The chart below shows inflation within the Eurozone from 2007 to date. The regions of the chart in red are those points where that rate was less than zero. And therefore deflationary forces were at work. 

EU Inflation Rate MoM

Long-term downtrends and globalisation

The structures that governments had put in place to remove volatility from the economic cycle, i.e. globalisation and free cross-border trade, now started to work against, and undermine central bank's efforts to reflate their economies. By opening up international trade, and moving businesses and production "offshore", western economies became directly exposed to long-term trends within the emerging markets.

Global inflation and Consumer Prices - Annual Percentage Change

The chart above shows us one of the most powerful of these. Namely the trend in global inflation, between 1980 and 2016, the low-cost labour pools of Asia, in particular, those within an industrialising Chinese economy, were put to work. The costs of production fell and continued to fall as new manufacturers become ever more efficient. The cost of finished products also fell sharply, importing deflation into the developed economies when they were shipped to the end consumer. Flat screen TVs are a prime example of this trend.

Long-term changes in price 

It’s not just globalisation which has driven down prices and inflation. Technology, innovation and increased productivity were equally important. These trends are not new and can be traced back hundreds of years. As an example consider the chart below that tracks the cost, of an hour of artificial light from  1301 to 2006.

The Price of Lighting in the UK in GBP

Today modern technology drives even greater productivity gains in areas such as processing power, cloud computing, storage and connectivity. It creates highly efficient logistics chains, allowing the offshore production of even the most high-tech goods in factories in the developing world.  

The greatest impact is from the internet. The World Wide Web has been instrumental in flattening price curves, removing middlemen and shortening supply chains across the globe in every conceivable area of commerce. 

Just take the example of trading the markets. Trading software and platforms are today free at the point of use and available anywhere we have connectivity. Trading costs have also fallen, and in some cases, commissions have been done away or reduced to a sum that amounts to an admin fee particularly as we have grown used to expecting more and to pay less for it. That trait has led to whole new business concepts that follow this freemium approach. 

Consumer behaviour and expectations on price have also been driven by large disruptors such as Amazon. Who operate at substantial scale. Even in areas where the likes of Amazon do not compete directly, such as in the UK grocery market, consumer expectations have become so attuned to low prices that competition between the incumbents has become cutthroat. Ominously for them, Amazon has now entered the grocery market through its acquisition of the US chain Whole Foods. Its first action was to reduce prices dramatically. And to offer further discounts to members of its Amazon prime division. These price cuts are likely to directly affect broad measures of US inflation over the coming months.

There is also a question of how we calculate inflation in the modern world. Traditionally this has been done by measuring the cost of a basket of goods and then adding in other essential items Commentators including myself have asked - shouldn't we be able to measure inflation more directly in this age of price comparison websites, intelligent payment methods and computerised tills? We may see some  new metrics emerge in the near future as organisations such as the UK’s Office for National Statistics developed  “prices paid models and tools."

A concluding thought

Inflation remains a rare beast in the developed economies, particularly in wages. And until such time as we see that excess demand return on a permanent basis, central banks, such as the ECB, the RBA, the BOE and the BOJ will remain reluctant to raise interest rates, bring an end to QE and head further down the road towards normalisation. But as we have seen recently in GBPUSD, when the market senses that a central bank could be about to act, there is no shortage of price movement and trading opportunities. So keep watching those inflation numbers.

 

For more analysis, you can check out Darren's Daily Market Update (key market news in minutes) or follow him on Twitter.

If you're looking to grow your Forex knowledge, subscribe to The FX Lounge, Pepperstone's new education website dedicated to helping improve your trading.

 

Try Pepperstone Today

Experience forex trading as it should be.

The information provided here reflects the view of the analyst and does not reflect the opinion of Pepperstone. The information has been provided without any alteration or verification. Pepperstone does not represent that this material is accurate, current, or complete and it should not be relied upon as such. The Information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any particular trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.