INFLATION, DISINFLATION, DEFLATION, WHICH OPTION?

ECONOMIC ANALYSIS

After forty years of price stability, but especially after two years of unusually high inflation, investors are closely scrutinising price developments. They are trying to determine which environment they will soon face: inflation, disinflation, or deflation? While inflation is less desirable than disinflation, deflation is a real scourge.

For the record, price developments can take three distinct forms:

• Inflation reduces the investment capacity of companies and the purchasing power of consumers. It also leads to an increase in central bank interest rates.
• Disinflation is the reassuring scenario in which the major economies have been operating for the past few months: prices are rising but at a slower pace. This situation makes it possible to anchor inflation expectations and not disturb the economic players.
• Deflation is a particular concern. Businesses and consumers delay purchases in the hope that prices will continue to decline. This fall in demand fuels the contraction in prices, generating a deflationary spiral. At the same time, the debt burden is increasing in real terms, making it increasingly unsustainable.

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The deflationary spiral that has been raging in Japan for the past thirty years illustrates how this is a worst-case scenario. In order to get out of it, during the Great Depression of the 1930s, the United States had to implement the "New Deal", devalue the dollar, and tighten regulations in the financial sector.

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To forecast inflation, it is useful to break it down into two aggregates:

• A "core" component linked to the business cycle (see Figs. 2 & 4). If the economy is overheating, core inflation accelerates. And vice versa. The gap between the actual level of Gross Domestic Product (GDP) and its potential level, which economists call the "output gap", provides a good estimate of future core inflation.
• A "non-core" component dependent on energy and food prices (see Figs. 3 & 5). Unsurprisingly, the oil price index helps to forecast this volatile component of inflation.

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The output gap on the one hand and oil prices on the other were incredibly effective in forecasting inflation until 2019. However, since the pandemic in 2020, price increases have been unusual. Core inflation has risen two to three times faster than the business cycle pressures in the US and Eurozone would suggest (see Figs 2 & 4). The fiscal policies implemented by governments during the health crisis were disproportionate. They generated so much excess savings among households that companies were left with far too much pricing power. At the same time, during the various phases of lockdown and reopening of the economies, shortages followed one another. Supply was constrained by low production as well as by transport and sourcing issues. Together, these phenomena have generated about 3.5% of additional inflation per year... and they are struggling to disappear.

Since March 2022 and the war in Ukraine, energy, fertiliser, and grain prices have soared. The geopolitical context has contributed to a surge in non-core inflation by a further 3% to 5%, depending on whether you are in the US or the Eurozone (see Fig. 3 & 5). Today, although the war continues to rage, the prices of these commodities have stabilised and are therefore no longer contributing to inflation.

In order to go further in the analysis, it is necessary to integrate some forecasts into our econometric modelling. The assumptions used are a continuation of the extraordinary distortions that have prevailed since 2020, an economic recession and active interventionism by the Organisation of the Petroleum Exporting Countries (OPEC). In this scenario, the output gap is expected to move into negative territory in the US and the Eurozone, while oil prices will find it difficult to fall sharply and lastingly. Consumer prices will therefore continue to rise, but at a slower pace than in 2022, both in the United States and in Europe, allowing inflation to stabilise between 2% and 4% (see chart of the week).

Around this central scenario, everyone will be free to adjust the assumptions. Mechanically, each point of GDP growth will generate 2% additional core inflation in the US and 1% in the Eurozone. Each 40% increase in oil prices will generate 1% additional non-core inflation on both sides of the Atlantic.

However accurate the models used may be, they are not perfect. They do not take into account health crises, geopolitical tensions, or climatic events. For example, if the summer is hot or the winter is freezing, energy consumption will be affected. Similarly, if the war in Ukraine or tensions over Taiwan escalate, the price of food, fertilisers or semi-conductors will face upward pressure. In these cases, inflation will accelerate.

Many institutes publish leading indicators and inflation forecasts for 12 or 24 months. They are not necessarily more reliable than our models. In contrast, opinion surveys of purchasing managers are very powerful in forecasting inflation 3 to 6 months ahead, in the US (see Fig. 6) or in the Eurozone (see Fig. 7). This reinforces the first phase of our scenario: inflation should continue to fall in the coming months. The purchasing managers' surveys to be conducted by the end of the year should validate the second phase: a stabilisation of inflation between 2% and 4% in 2024.

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Typically, long-term inflation is driven by wage growth. Faced with an initial rise in production costs, and in order to maintain their margins, companies increase their selling prices. If wages rise in tandem, to avoid a loss of purchasing power for households, then a wage-price spiral is set up. The phenomenon is perverse as it is a two-way street: the increase in one leads to an increase in the other. In the United States, according to the latest data, the average hourly wage rose by 4.4% in one year (see Fig. 8). It is clearly decelerating since its rate of 6% in March 2022, but still significantly higher than the range of 1.6% to 3.6% observed over the previous decade and which Jerome Powell would like to see restored as soon as possible. To do so, the job vacancy rate would have to contract more sharply, and the unemployment rate would have to rise (see Fig. 9). Once again, the scenario of a stabilisation of inflation at a relatively high level is confirmed.

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The inflation rate is falling significantly but prices will remain high. Initially the result of a supply shock and an over-stimulation of demand, inflation is now linked to wage pressures and extends to the service sector, while energy prices stabilise (see Fig. 10). As in the 1970s, from oil shocks to energy counter-shocks, from restrictive monetary policies to stimulus measures, inflation will fluctuate widely but will remain structurally high (see Fig. 11).

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Conclusion

Investors' fears of a further acceleration of inflation in 2023 are fading: disinflation is underway and taking place faster than expected. In both the US and Europe, our central scenario remains a stabilisation of price dynamics, no longer between 4% and 6% as previously expected, but between 2% and 4% per year.

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RETURN ON FINANCIAL ASSETS