Inflation, liquidity and asset markets 􀂄 BofA Merrill Lynch,

Inflation, liquidity and asset
markets
􀂄 Global: inflation, liquidity and asset markets
In the past year, the big surprise relative to the consensus forecast is not that
global growth is slowing, but that inflation is falling. Looking ahead, we expect
further central bank easing. The low-inflation-high liquidity story is far from over.
United States: debt in a time of low growth
A fair reading of the recent debt debate is that high levels may have a small
impact on trend growth, but results from distant countries and times are not very
relevant to the US today.
Euro area: fiscal easing - don’t get your hopes up
We discuss the potential easing and argue that although the policy stance may be
relaxing; this will not provide a strong tailwind to growth, so is unlikely to change
the ECB’s view on the outlook.
Japan: possible sources of inflation
Larger declines in consumer durable goods prices and no rise in service prices
have been the two major sources of deflation in Japan. The reversal of these
trends is necessary for Japan to have inflation.
Emerging Asia: Indonesia - commodity or consumer driven?
Indonesia has held up well relative to other large commodity exporters such as
Brazil and Russia. The growth engine has shifted to consumer spending from a
decade long commodity boom.
Emerging EMEA: commodities – digging deeper
A simulation of fundamentals without the rise in terms of trade since 2002
suggests lower GDP per capita but higher public and external debt and thus
worse sovereign ratings.
Latin America: slow investment growth in 1Q
Investment in LatAm expanded only 2.1% yoy in 1Q, according to our estimates.
We updated our monthly investment indices, which help predict quarterly National
Account investment data.
UK: weaker wage growth for the doves
We expect the BoE’s Inflation Report to show a slightly softer near-term inflation
outlook, though still remaining above target until 2015.
Canada: helplessly hoping
We believe the Bank of Canada is overestimating the potential for exports to drive
growth in 2013. In our opinion the export rebound is a 2014 story, not a 2013 one.
Australia: RBA surprises – what more could be in store?
The RBA cut its cash rate by 25bp to an all-time low of 2.75%. The language of
the post-meeting statement leaves the door open to another cut next month.

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Global overview
Inflation, liquidity and asset markets
􀂄 In the past year, the big surprise relative to the consensus forecast is not that
global growth is slowing, but that inflation is falling and in many cases is well
below central bank targets.
􀂄 Low inflation has big implications for markets: it helps explain ongoing central
bank easing, the simultaneous rally in the stock and bond markets, and the
outperformance of “defensive” stocks.
􀂄 The low-inflation-high-liquidity story is far from over, in our view. In the
medium term, we expect further central bank easing. In the longer term, we
expect low inflation to allow a relatively benign exit from super-easy
monetary policy.
Inflation is surprisingly soft…
The big story this year is not the US spending sequester, the China slowdown or
the ongoing European recession. The big story is inflation, or more precisely, the
lack thereof. After peaking in the summer of 2011, inflation has steadily fallen
globally and in both the emerging and developed markets economies (Chart 1)
Our global inflation index goes back to 1996 and over that period inflation has
averaged 3.1% overall, 1.9% in DM and 6.6% in EM; the corresponding numbers
for this March were 2.2%, 1.3% and 4.0%. Of course there are some exceptions:
inflation has been defying gravity in the UK for a number of years and is high in
some major EM economies such as Brazil and Mexico.
The weakness has come as a surprise to economic forecasters and an even
bigger surprise to many market participants. Critics of the major central banks
have repeatedly warned that easy policy would lead to runaway inflation.
However, in reality inflation is falling, not rising. As Chart 2 shows, growth has
been surprising slightly to the downside; as Chart 3 shows, the downward
surprises to inflation have been even more persistent.
…and likely to stay soft
QE critics continue to worry about liquidity-induced inflation. The monetary base
(cash plus reserves) for the G4 continues to grow rapidly as the Fed and BOJ
continue their aggressive asset buying programs. Broad M2 money growth has
also been strong at times. However, these aggregates have been remarkably
poor predictors of the inflation outlook. For example, Table 1 shows the
correlation between the growth in the US monetary aggregates and CPI inflation
at various lag lengths. The correlation is always small and half of the time has the
wrong sign – strong money growth “causes” low inflation.
As we have noted many times, this disconnect reflects two missing links in the
chain of causation from reserves to inflation. First, bank reserves are not “money”
in any meaningful sense. Higher bank reserves only turn into “money” and create
inflation risks if banks lend them out, causing a spending boom. However, today
and for the foreseeable future, banks are happy to deposit their excess reserves
back at their central bank. Bank lending in the QE countries is being determined
not by liquidity but by concerns about the size of balance sheets, new regulatory
and capital requirements and legacy bad assets. QE countries are experiencing
below normal lending and spending growth: in the past 12 months private sector
lending by major financial institutions has risen just 3.7% in the US and 1.8% in
Japan and has fallen 1.5% in the Euro area and 1.8% in the UK.
The second disconnect is that while there have been brief bouts of stronger
money growth, this mainly reflects high demand for liquid assets. After watching
housing and equity market collapses, both households and firms are overweight
cash. This is a sign of risk aversion, not incipient inflation.
While the liquidity models are not working, two other indicators are: commodity
costs and spare capacity. Both point to lower, not higher, inflation. Commodity
prices were a major factor in the acceleration of inflation in 2010-11. The CRB
index almost doubled from December 2008 to April 2011 (Chart 4). Initially, this
showed up only in headline inflation, but after two years of relentless pressure it
crept into the core. History looks unlikely to repeat itself. The CRB index has
fallen 17% in the past year. Our commodity team expects some of this weakness
to reverse in the second half of the year, but that still leaves commodity prices
well below their peak. This small rebound could add a couple tenths to headline
inflation, but will likely have no discernible impact on the core.
Rising slack adds to the case for weak inflation. Europe had a very brief recovery
and is now moving backwards, with the unemployment rate hitting the highest
level in the 14-year history of the Euro. The US still has not fully recovered from
the 2008-9 crisis and the 7.5% unemployment rate is well above our 6.0% to
6.5% estimate of the NAIRU. We believe global potential growth has slowed to
3.5%; actual growth was just 3.1% last year and is expected to be just 3.2% this
year. In other words the output gaps are widening. We have estimated a simple
model of core inflation for the G-4 – including lags of the core, the output gap and
food prices (Table 2). It suggests the core will continue to inch lower from 1.6% in
Q4 2012 to 1.4% at the end of this year and 1.3% at the end of next year.
It ain’t over ’til the Fed leader sings
This is not the first time we have made this point, but it is worth pounding home:
central bankers disagree about many things, but virtually all agree on targeting
inflation at about 2%. Modern central banks want a cushion against deflation and
they want interest rates in normal times to be well above zero.
Low and below-target inflation in large measure explains the ongoing easing. This
process is far from over:
􀂄 For years the Bank of Japan had essentially given up on fighting deflation,
arguing that structural factors, not monetary policy, determined inflation. Now
the new BOJ leadership has adopted aggressive Fed-style QE. Looking
further ahead, the BOJ can potentially “out-Bernanke” the Fed because
unlike the Fed it has the power to buy equities and other risk assets.
􀂄 The Fed has quickly tabled its QE tapering talk and has shifted to a balanced
directive. We believe they are more likely to increase than reduce QE this
year. We don’t expect tapering until next spring.
􀂄 Last week, the ECB cut interest rates a month earlier than expected, noting
in their bulletin that the decision was “consistent with low underlying price
pressure over the medium term.” We expect an additional cut at the next
meeting. Looking further ahead, we expect Draghi to be tested on his
promise to “do whatever it takes.”
􀂄 In Australia, the RBA quickly pivoted from arguing that interest rate cuts were
“gaining traction” to pointing to low inflation as a reason to cut rates. Our man
down under, Saul Eslake, thinks the window is open for more cuts.
􀂄 Emerging markets continue to cut. Most recently Korea, Poland, Turkey and
India lowered rates, and we expect Russia to follow through next week.
It’s all about the Benjamin…Mario, and Haruhiko
In our view, the low-inflation-high-liquidity story helps explain some major trends
in capital markets. Coming into the year, a popular view was that there would be
a “great rotation” out of bonds and into stocks. For example, the Blue Chip
consensus in December looked for US 10-year yields to steadily trend up from
1.9% to 2.2% by year-end. The stock market rally has certainly happened – the
S&P 500 is up 14% and the world MSCI is up 12% so far this year – but bonds
are down, not up. This suggests that liquidity, rather than growth, is driving the
markets. The performance within the market also points to liquidity effects, with
defensive stocks outperforming cyclicals.
Looking ahead, we expect the growth picture to get a bit more challenging as
both the US and Europe disappoint relative to the consensus. However, we also
believe the low-inflation-high-liquidity story is far from over. With persistently low
inflation, central banks will continue to respond to any signs of weakness.