“The only function of economic forecasting is to make astrology look respectable” – John Kenneth Galbraith
Deflation in the UK
This week, the UK’s Office for National Statistics (ONS) announced that consumer prices had declined by 0.1% in April from a year earlier for the first time since 1960. The picture painted by data in Europe this week is broadly similar. There remains very little inflation to speak of anywhere in the developed world right now. To many this suggests that inflation is a beaten foe, a relic of a time that, for many city forecasters, exists only in text books. Deflation may feel like the more pertinent threat, particularly in light of this week’s data and the ever present miasma of morose economists telling us that there is something wrong with the world economy.
Regular readers will know that unlike the consensus, it is inflation that we see as the more pressing threat to economies and financial markets. This is not to suggest that we see a return to the double-digit levels of inflation that dogged much of the 1970’s. It is more the case that on a one to two-year view, we see inflation as more likely to surprise current expectations positively rather than negatively.
Wages are at the heart of this belief – as unemployment continues to fall in both the US and the UK, the increasing scarcity of labour in these economies, even allowing for compositional changes to the labour force, should see wages continue to turn up.
The problem with forecasts
The current consensus that inflation will remain subdued for the foreseeable future, allowing central bankers the flexibility to normalise interest rates in a leisurely manner is perhaps just another example of the inductive fallacy of using the recent past to explain an ever unknowable future.
A good example of this tendency can be seen in a recent survey by our colleagues at Barclays Investment Bank of their institutional clients, which concerned the likely level of German Bund yields by the end of the second quarter. The vast majority of the respondents went with a continuation of the trends that were in place at the time the question was asked. If German yields hold their current level until the end of the quarter, which of course is by no means guaranteed, then only 5% of the survey respondents will have correctly guessed at even the rough direction of the market.
As suggested last week, this correction in German government bond yields and the wider fixed income universe likely has its roots in a little less pessimism on the prospects for inflation. This is a journey that may only be in its infancy if we are right about the prospects for global economic growth and inflation over the coming quarters and years.