The deflationistas have been making a lot of noise lately, egged-on by the lack of meaningful inflation out of the U.S.. Just today, Nouriel Roubini’s bond strategist warned that the entire developed world no longer had the ability to create inflation.
Thing is, we’ve pointed out before that if deflation is on the way, then bond markets will be caught completely flat-footed, since their inflation expectations, based on bond pricing, remain pretty normal. You can see this here. It’s not impossible that bond markets could be wrong, but one has to really question one’s assumptions if betting against this. And if you really think the bond market’s inflation expectations are wrong, then you can go show your conviction with a bet in the market any day of the week.
Anyhow, Deutsche Bank’s Peter Hooper has come out and said that ‘Deflation Risk is Overrated’. So perhaps he’s in the same camp.
The recent downtrend in core inflation has been troublesome, but we find empirical evidence to support the view that so long at the economy continues to recover, even at a sluggish pace, inflation will stop well sort of falling to zero. Indeed, it could very well bottom soon and could even bounce back a bit in the near term.
Our analysis finds that the relationship between economic slack and core inflation, which had weakened substantially in the 1990s, has strengthened again in recent years. However, while strengthening, the relationship also appears to have changed. Unlike the relationship that prevailed during the 1970s and 80s, “speed” effects appear now to have become a good deal more important than “gap” effects. That is, the positive effect on inflation of diminishing slack is now more important than the negative effect of the level of slack itself. This says that so long as inflation expectations remain stable, inflation will begin to rise again as unemployment trends lower.
This means the Fed’s “low for long” policy could well be abbreviated as soon as the pace of economic recovery begins to show clear signs of picking up sustainably.
Thus you can see below in blue how Deutsche’s model actually predicts core inflation to start rising again soon, and to continue doing so out to 2012. If they’re right, watch the deflationists lose steam.
Here’s his (better) version of the inflation expectations chart we did previously on The Money Game:
(Via Deutsche Bank, Deflation Risk is Overrated, Peter Hooper, 14 July 2010)
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