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Inflation and deflation; the ugly sisters of finance

March 10, 2017 • By TAB team

Inflation and its uglier sister, deflation, are not glamorous. They barely get any media coverage until something goes seriously wrong. Most people don’t know much about them and they don’t want to know. But they should, because inflation and deflation affect every aspect of our lives.

Inflation and its uglier sister, deflation, are not glamorous. They barely get any media coverage until something goes seriously wrong.

Most people don’t know much about them and they don’t want to know. But they should, because inflation and deflation affect every aspect of our lives. After all, we’re all consumers.

Inflation and deflation not only colour our experience as consumers. Eventually, more than any other factor, they determine asset prices and their direction. This is why we should care about them.

Millennials don’t care about inflation, because they’ve never lived through it. But their parents remember the chaotic and troubling 1980s when inflation was rampant.

In September 1981, yields in the US reached 15% and bonds were labelled ‘certificates for confiscation’. Nobody wanted to hold them. Investors were unable to foresee inflation morphing into disinflation and eventually winding up as deflation.

Thus began a great bull market, leading to three decades of extraordinary gains in bonds, property and equities around the world. The going was good. Humanity prospered.

Today's economic and political landscape has been shaped by the glacial drifting down of prices. That change is imperceptible and yet surprising. And just as inflation can easily switch into deflation, so too deflation can morph into inflation, with profound consequences – not just for markets, but politics too.

As inflation and deflation tend to be long lasting and entrenched, when they switch there is inertia and widespread denial. 2016 hinted at the beginnings of such a reverse, as bonds flirted with negative yields. It seems the bond bull has been tranquilised and deflation is giving way to rising prices. But nobody on the street is calling for sustained rises. More inertia. More denial.

And there are signs that inflation may trend higher. China has been a huge disinflationary force and curtailing exports might have serious inflationary consequences. An iPhone manufactured in America would cost $2000. A pair of Levi’s, $348. Trump’s protectionist ‘Made in America’ rhetoric could spell the end of cheap imported goods.

On top of this, the US administration is looking to bolster a robust economy with pricing pressures steaming up on goods and services. Should this continue, long entrenched trends will reverse, with nefarious effects over asset prices – some of which are not obvious today.

We can learn much from economic history, but the impact of this latest shift on economics, asset prices and political processes is impossible to predict.

Trump is unleashing economic forces he cannot foresee, let alone control. If inflation begins to take off, The New Normal could turn into The New Abnormal, with huge consequences that reach beyond the boundaries of finance and economics into domestic and international politics.

We live in an interconnected world where capital, labour and goods are exchanged in a global marketplace. Imperceptible macroeconomic shifts might not be headline news, but they can be just as important and disruptive as geo-political war games to the global order.

Relationships between superpowers are in a state of flux, with the new US administration yet to define its economic and military relationships with global players like China, Russia, Germany, even the UK. The dance of the Ugly Sisters will only complicate this delicate process.

In our efforts to understand the global economic and political picture, it’s critical that we look at the right variable. Inflation is important because it determines the direction of asset prices very powerfully. So we should keep a very close eye on this indicator.

The Ugly Sisters might not be en vogue, but they deserve to be treated seriously. Everything else is a sideshow.