Is inflation about to dent markets?

It is always sobering when one of this writer’s year-ahead predictions appears obsolete after only a few days. And it was only last week that his belief that policy may remain easy during 2011 already started to be questioned, with evidence that global inflation could become a key issue in 2011.

Thus far, with the high-profile exceptions of China in the emerging world and the UK in the developed world, there has been relatively little concern about inflation. Our proprietary Deflation Alert Measure (or should we rebrand it as an Inflation Alert Measure?) has turned upwards sharply and is rapidly approaching the inflation zone that signals interest-rate pressures.

This has been caused by all three of the model’s components: commodity price breadth has reached the top of its range; stock/bond correlations are normalising rapidly; while inflation expectations have risen to the top of a long-term range, although they have not broken through it.

These indicators largely reflect what market participants are thinking and contrast with real economic data. The macro data show that the major OECD economies have significant levels of spare capacity with sizeable output gaps. Indeed, these output gaps suggest that it will take several years before capacity pressures rise and lead to faster inflation. Moreover, there is little evidence that organised labour has regained pricing power judging by limited wage pressures and little sign that profit margins and returns on equity are being eroded. The standard Taylor rule measures of monetary policy (which estimate the equilibrium interest rates using output and inflation gap measures) indicate that equilibrium US interest rates should be negative – around -4% to -5%

However, at a global level there may be little or no spare capacity. BNP Paribas has estimated that the global output gap has now closed, threatening rising inflation over the next 1-2 years. Their measure includes the emerging world and shows there was a negative output gap in 2008 just before world economy went into recession. Apparently, the recession of 2008/09 only opened up a small output gap, which has since closed given the economic recovery in 2009/10

There are other reasons for worrying about capacity pressures. One drawback of traditional output gap analysis is that it is based on national account data that are neither timely nor consistent. An additional concern is that the last downturn has led to scrapping of the capital stock (including obsolete computers), which could mean that the effective spare capacity is less than suggested by the official data. There is also a sad human dimension to this, because the long-term unemployed tend to become less employable as their skills degrade due to inactivity. Once more, this could have the effect of reducing effective spare capacity.

An alternative measure is to use forward indicators to gauge inflationary pressures. Jonathon Griggs, the CIO of J.P. Morgan Asset Management’s Global Currency Team has produced some proprietary policy indicators, which assess the extent to which central banks may need to raise interest rates. His data show that the UK has just crossed the divide that signals rising interest rates, while the other G4 economies (US, eurozone and Japan) are also approaching this threshold. Interestingly, Jonathon’s data show that the US is the laggard in this process, which may explain the accommodative noises still coming out of the Fed.

Policy risk could thus challenge markets this year – and perhaps sooner than the consensus is currently factoring in. Credit Suisse estimates that the forward markets are pricing in only 28bp of tightening in interest rates in both the US and the eurozone and 64bp in the UK. This relative calm at the short end of yield curves would end rapidly if investors felt that policymakers were “behind the curve” in their responses to inflation pressures.

At present, there is more investor concern about emerging market inflation, with several Asian markets having negative real interest rates (though Brazil is the laudable exception). As the global expansion reduces spare capacity during 2011, the current easy monetary conditions are increasingly likely to feed through into rising goods prices rather than higher financial asset prices. The inflation genie may be letting himself out of the bottle