What will inflation be in the new economy?
As we emerge from the Great Recession, it’s reasonable to ask what inflation is going to do. After all, inflation determines interest rates, and interest rates determine what the present value of future cash flows are going to be. If inflation goes up, then the present value of all financial assets is less, and stock and bond prices fall.
History is of value as a starting point, but the world is changing. Countries are far more interconnected now than in the past. So we ought to talk about inflations, not inflation, and we should try to understand where it has been before predicting where it will go.
Over the past 25 years inflation has been about 2 ½ percent in the US and in Europe. In the BRIC countries—Brazil, China, India—it’s been more like 7%. Conventional wisdom is that what we’ve seen is what we’ll get—lower rates of inflation in the developing world, and inflation reverting to its mean level in the West.
But the past may not be prologue. Consumers here and in Europe have been through the wringer, and their savings rates seem to be moving up. At the same time, as the global economy rebalances the developing world is likely to see lower savings rates. That means that consumer demand is likely to be muted over here, but stronger in China, India, and Latin America.
So inflation in the US and in Europe may ratchet down another notch to 1% or even lower, while moving up towards 10% in the developing world. That could mean stubbornly low interest rates here and higher rates in the BRICs. What does this mean for asset prices? Hold on to your hats! We’re in for some interesting times.
Douglas R. Tengdin, CFA
Chief Investment Officer
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