But surely, an increased supply of money must be inflationary? No. Printing money is inflationary only if it leaves the private sector with excess cash which they try to spend on goods and services, thus pushing their prices up. But this hasn’t happened to any great degree, because the Fed’s increased supply of money has been largely matched by an increased demand for it. Banks’ deposits with the Federal Reserve, for example, have surged since QE began.
Instead, there are fundamental reasons why inflation is low. China’s slowdown has left the country with excess capacity, which is holding down the prices of many manufactured goods. Although commodity prices have risen since April, they are lower than they were in March. And mass unemployment is holding down wage and price growth. Many economists believe the US has a non-accelerating inflation rate of unemployment of around six per cent. It’s current rate is 7.4 per cent.
However, David Woo at Bank of America Merrill Lynch says the fall in inflation might be coming to an end. He points out that, just lately, month-on-month core inflation rates (that is, excluding food and energy) on both the CPI and PCE measures have picked up from 0.1 to 0.2 per cent. One reason for this might be that productivity growth has slowed; Charles Dumas at Lombard Street Research points out that the fact that employment has risen this year even though the US economy has grown only modestly points to output per worker stagnating. Unless this leads to lower wage growth – and this has for months been stable at around two per cent per year- it must mean either a squeeze on profit margins or higher inflation. However, with demand still quite weak, firms’ room to raise prices is limited.
Of course, none of this means inflation will stay low forever. Eventually, demand will grow sufficiently to trigger significant price rises. And it’s possible – as Chicago University’s John Cochrane has argued – that the US’s dire long-term fiscal position will lead to inflation. But these are more distant dangers. For now, the inflation outlook is OK.
This matters for the UK, simply because many of the forces for low inflation are global ones. Unless sterling falls – which is a possibility rather than a central case – we’ll not be importing much inflation. This, allied to price rises in late 2012 dropping out of the inflation data, is one reason why most economists expect inflation to fall over coming months.
This, of course, has a direct implication for monetary policy. With inflation well-behaved, central banks around the world can keep monetary policy loose.
Whether this is good for equities is, however, not so clear. As we saw in June, even the faintest whiff that the Fed will eventually stop QE – which of course it must do sometime – can hit the market hard. It’s possible, therefore, that even a slight flicker of inflation could have a disproportionately adverse effect upon shares.
