The Real Inflation Threats

Inflation generally refers to the pace of increase in consumer prices.

1.  Historical inflation data

1970s

Consumer prices were rising at a double-digit pace and wreaking economic havoc all over the world.  

In early 1980s, they began to recede under pressure from rising global competition and a concerted attack by central banks.  

Raising interest rates to painful heights, central banks choked off money flows and won the war on inflation just about everywhere.

1981 to 1991

The average rate of inflation in developed nations fell from 12% to just 2%, where it remains today.

Meanwhile, in emerging nations, the average rate of inflation peaked at a staggering 87% in 1994 and reached the hyperinflationary triple digits in major countries like Brazil and Russia.  Then, over the subsequent decades, it receded to its current, much calmer rate of just 4%.

2.  Average inflation rates today

Any emerging nation with a rate of inflation much above 4% or any developed nation with a rate much above 2%, has cause for concern.  

In a world where double- and triple-digit consumer price inflation is a rare threat, the outliers are worth watching closely because they are out of balance and seriously at risk.

3.  Traditional thinking focuses on consumer price inflation only

High consumer price inflation is a growth-killing cancer

In the short term, 

• rapidly rising prices compel central banks to raise interest rates, 
• making it more expensive for businesses and consumers to borrow.  
• High inflation also tends to be volatile, and its swings make it impossible for businesses to plan and invest for the future.

Over the longer term, 

• inflation erodes the value of money sitting in the bank or in bonds, thus discouraging saving and 
• shrinking the pool of money available to invest in future growth.

4.  Post crisis of 2008 slow-growth environment fears outright deflation

The central banks are now fighting a very different war.  

Central banks often worry that inflation may be too low, not too high in the slow-growth environment that took hold after the crisis of 2008.  

In developed countries, instead of raising rates to make sure inflation doesn't increase too far above a target of 2%, they now cut interest rates when inflation is falling too far below 2%.  

Their big fear is that low inflation will lead to outright deflation - the dreaded but overblown "Japan scenario."

5.  Low inflation and deflation can be bad (depressed demand) and can be good (driven by new innovation and expanding supply)

History, shows that neither low inflation nor deflation are necessarily bad for economic growth.

"Bad deflation"  

Japan suffered a rare bout of "bad deflation" after the collapse of its stock and housing bubbles in 1990.  

• Consumer demand dried up, prices started to fall and shoppers began delaying purchases in the expectation that prices would fall further.  
• The downward spiral depressed growth for two decades.  

"Good deflation"

However, deflation can also follow a new tech or financial innovation that 

• lowers production costs and 
• boosts economic growth.

High inflation is always bad for growth, deflation maybe neither bad nor good

If inflation is too high, it is almost always a threat to growth but the same cannot be said of low inflation.  

Even if low inflation threatens to devolve into deflation, it could be good for growth if the falling prices are driven by new innovations and expanding supply, rather than by depressed demand.

6.  Post 2008 low interest rates environment

After central banks won the war on high consumer price inflation, they cut interest rates to levels that have fueled a massive run-up in prices for 

• financial assets, including stocks, bonds and 
• houses.  

In recent decades, stock market and housing bubbles have been increasingly common precursors to financial crises and recessions.

7.  The Real Inflation Threats

Economists have been very slow to recognize this new inflation threat, and central banks have been very slow to think outside their official mandates, which focus on stabilizing the economy by controlling inflation in consumer prices, only.  

But successful nations will control both kinds of inflation, 

• in consumer markets and 
• in financial markets.

Conclusions

The general rule is that strong growth is most likely to continue 

• if consumer prices are rising slowly or 
• even if they are falling as the result of good deflation, driven by a strengthening supply network.

In today's globalised economy, cross-border competition tends to 

• suppress prices for consumer goods but 
• drive them up for financial assets (stocks, bonds and houses).  

Thus watching consumer prices is not enough.

Increasingly, recessions follow instability in the financial markets.  

To understand how inflation is likely to impact economic growth, you have to keep an eye on stock and house prices too.