Study Inflation 20vs 20Deflation_en_low

8/2/2019 Study Inflation 20vs 20Deflation_en_low

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Investors

Insight

VontobelAssetManagement

Inflation versus deflation:

A guide for investors


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The monetary policy of all major central banks is focused

on stimulus. Interest rates are at all-time lows of between

0% and 1%, and money supply aggregates are growing

at a double-digit pace. Due to these conditions, many

investors are concerned that inflation could soon jump

sharply. However, there has not been a meaningful rela-

tionship between money supply growth and inflation

for some time. More important for assessing monetary

policy in terms of inflation is the so-called Taylor rule,

which is currently indicating that the monetary policy

of major central banks is correct.

There has not been a meaningful rela-

tionship between money supply growth

and inflation for some time.

In the coming years, inflation is therefore likely to stay

lower than many people are expecting. However, should

monetary policy turn out to be in error, the danger of in-

flation cannot be ruled out. Since 1900, commodities andto some extent equities have afforded the best inflation

protection during inflationary periods. In contrast, gold is

more for crisis protection than explicit protection against

inflation.

Introduction

This study is structured as follows:

Chapter 1 looks in detail at the basic causes of inflation

and indicates our inflation forecast for the coming years.

Chapter 2 addresses the question of how investors should

behave if they think that inflation will rise sharply. The

chapter also discusses real i.e. inflation-adjusted yields

for the major asset classes. The special role of gold will be

discussed in a separate section.

Chapter 3 shows the performance of asset classes duringdeflationary periods.

Chapter 4 is a summary and also includes conclusions for

investors.

Dr Thomas Steinemann,Chief Strategist of the Vontobel Group

Oliver Russbuelt,Senior Investment Strategist

Dr Walter Metzler,Senior Economist

September 2010


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4

The expansive monetary policy over the past two years

has fuelled fears that a dramatic increase in inflation may

be unavoidable. In actual fact, because of the global fi-

nancial crisis, global interest rates and as a result bond

yields have never been so low. In addition, central banks

have implemented quantitative easing, which is a continu-

ation of the lowering of interest rates by other means. To

put it simply, quantitative easing is an expansion of the

balance sheet of a central bank, in that the central bank

buys securities and undertakes longer-term refinancing by

printing money. As a result of the deep recession in 2009,

core inflation (consumer price inflation without food andenergy prices) in the industrialized nations is currently

very low, which raises the question of what exactly it is

that determines inflation.

In the 1970s, the dominant idea was the monetarist view

that inflation was the result of too much money chasing

too few goods. But in the 1980s the view of an empirical

connection between money supply and inflation (see

chart 1) was increasingly rebutted.

This means that the money supply trend can no longer

explain or forecast inflation. For example, growth in the

US money supply from 1980 to 1995, a period in which

inflation fell sharply, was in fact slightly higher than in the

inflationary years of the 1970s. Conversely, monetary

expansion slowed between 2005 and 2008, but inflation

moved higher anyway. For these reasons the US Federal

Reserve, the Bank of England and the Swiss National Bank

no longer set money supply targets. Only the European

Central Bank does so, with respect to the M3 money

supply.

Despite the currently strong increase in the US moneysupply due to quantitative easing, it does not necessarily

follow that there will be a sharp increase in inflation.

Chapter 1:What actually drives inflation?

A leap in demand for liquidity during the financial crisis

lies behind money supply growth

The main reason why the US Federal Reserve increased

the money supply was to satisfy the huge increase in de-

mand for liquidity during the financial crisis.

Banks wanted to protect themselves against sudden out-

flows and reduce the risks on their balance sheets by

holding more liquidity. However, since banks had lost trust

in one another, they mainly sought out safe short-term

investments, such as reserves held with the central bank.

Due to the extreme uncertainty unleashed by the crisis,not only banks but also companies and households wanted

to hold more liquidity. If the central bank had not met this

sharp increase in demand, interest rates would have risen

considerably, which in turn would have exacerbated the

economic crisis.

It is easy to recognize that the increased money supply

was a response to greater demand in that banks have not

raised their lending to companies and households since

the financial crisis broke out, although they would have

been able to do so, by virtue of their substantial reserves.

Neither did the general economy deploy the greater sup-ply of liquidity to buy more goods and services. This can

be seen in that the ratio between GNP and money supply

the velocity of money in circulation has fallen since the

start of the financial crisis.

Inflation due to capacity utilization and monetary policy

As money supply has increasingly been an unreliable indi-

cator for inflation since the 1980s, experts have looked

at the utilization of productive capacity to help explain

the inflationary trend. This can be measured on the basis

of capacity utilization in industry or using the output gap.

The output gap indicates by how much current economic

production deviates from the potential. A positive

output gap means an economy is overheating, while a

negative output gap signals that utilization is too low.

How much inflation rises by during a phase of overheat-

ing depends on whether monetary policy is expansive or

restrictive. To assess whether monetary policy is appro-

priate, the Taylor rule has become established as a bench-

mark. It states that interest rates should be based on

(see box Taylor rule):

1. the output gap

2. the deviation of inflation from the central banks target

3. medium-term real interest rates and the current infla-tion rate

Source: Datastream, Vontobel

Chart 1: Inflation in the US has decoupled from money supply

since 1980

12%

10%

8%

6%

4%

2%

0%

2%

4%1965 1970 1975 1980 1985 19951990 2000 2005 2010

M1 money supply Inflation

Moving average


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5

The Taylor rule shows that US interest rates in the 1970s

were much too low, which explains why inflation was high

(see chart 3). The decline in inflation in the 1980s was the

result of the restrictive monetary policy of Paul Volcker,

the Fed chairman at that time, as interest rates were much

higher than the Taylor rule would ordain. In the 1990s

monetary policy was correct for the most part, which ex-plains the low inflation rate. From 2000 to 2004, interest

rates were too low, which pushed inflation up to 5%.

At the high point of the financial and economic crisis in

the autumn of 2008, the Taylor rule actually indicated

negative interest rates for the United States. But because

a policy of negative interest rates cannot be implemented,

the Fed turned to quantitative easing and brought about

a sharp expansion of the money supply by buying securi-

ties, which acted like an additional interest rate cut. This

action was in line with the Taylor rule and the dramatic

circumstances at that time.

A degree of inflation risk in the USThe Taylor rule is now indicating that the right interest

rate would be about 1%, but the key rate is still 0.25%. In

12 months from now the Taylor rule recommends on the

basis of our growth and inflation forecasts interest rates

of 1.5%. We expect, however, that the Fed will hike it s

policy rate only as far as 0.75% in the next 12 months.

This implies a degree of inflationary risk, especially as the

Fed is maintaining its quantitative easing for now. In addi-

tion, US fiscal policy is also highly expansive and will

probably remain so.

In our main scenario we expect, over the medium term,a modest and below-average economic rebound. This will

likely result in a more gradual shift of interest rates towards

Taylor level. Thus inflation could rise to 3% or even 4% in

the medium term, once deleveraging has been completed

a few years from now. If the economic rebound is even

stronger than expected, we believe inflation could reach

4% to 5%. There is also a danger that politicians could

have an impact on monetary policy, keeping it expansive

longer than is needed. In any case, we do not expect in-

flation to stay higher over a longer period, as the Fed

would turn to a more restrictive monetary policy if there

are clear signs of a sustained economic recovery.

Taylor interest rate = real money market target interest

rate + current inflation + 0.5 (inflation inflation target)

+ 0.5 output gap

Output gap =

Potential GDP = GDP at full utilization of the capitalstock and labour market

The inflation target and the real money market target

interest rate vary from one country to another. While

The Taylor rule

actual GDP potential GDP

potential GDP

25%

20%

15%

10%

5%

0%

5%

1970 1975 1980 1985 19951990 2000 2005 2010

Fed funds rate Taylor rule in 12 months

Chart 2: Output gap and inflation in the US

14%

12%

10%

8%

6%

4%

2%

0%

2%

4%

6%

8%1970 1975 1980 1985 19951990 2000 2005 2010

Out put Gap Inflat ion

Moving average



Chart 3: USA: Taylor interest rate and actual interest rate

Interest rates

the inflation target reflects a countrys stability culture,

the real money market interest rate depends largely on

potential growth.

Assessing monetary policy using the interest rate instead

of the money supply has the advantage that erratic

shifts in the demand for money can be eliminated as a

reason for wrong monetary policy. Friedmans (mone-

tarist) money supply rule would probably have led tohigher interest rates in the financial crisis because the

massive increase in the demand for money could not

have been satisfied.


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Gold provides protection at times of crisis rather than

inflation

It is remarkable that gold does not actually provide as

good a protection against inflation as is often assumed.

In the six inflationary periods of the 20th century, gold

posted a positive performance only once, between 1973

and 1981, when it returned a strong 15% annually. In all

other inflationary periods, gold did not generate a positivereturn. It should be remembered, however, that until 1973

gold was not freely tradable and the price of gold was

fixed. In addition, the private ownership of gold was pro-

hibited at times.

Gold has had three periods since 1900 in which it has per-

formed well. In the 1930s the value of gold went up by

decree under the gold standard, which triggered the first

period of higher gold prices, interestingly in a strongly de-

flationary period. After the Bretton Woods system was

abandoned in 1973, the price of gold could move freely.

Consequently, in the inflationary period that followed it

moved sharply higher in real terms. During the last infla-

8%

6%

4%

2%

0%

2%

4%

6%

8%

Commo-dities

CashEquitiesGoldReal

EstateTreasury

BondsCorporate

Bonds

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

Chart 6: Average real returns in the years with the highest

inflation rates

Real returns p. a.

tionary period from 1987 to 1990, however, gold posted

a negative annual return of 7%, faring the worst of all

asset classes.

The third and final gold price boom came after 2001, dur-

ing another potentially deflationary phase following the

bursting of the technology bubble. We therefore see that

periods of rising gold prices come during times of both in-

flation and deflation. If not inflation, what could explain

the price of gold? Chart 7 shows that the three periods of

rising gold prices all took place when weak equity markets

were moving sideways over an extended period of time.

In light of this, gold can be a good addition to a equity

portfolio, but it is more a protection during periods of cri-

sis than against inflation. Chart 8 shows that gold can

generate comparable returns to stocks only if dividends

are excluded. If they are included, we see that equities are

clearly superior to gold.1 Chart 8 illustrates the significant

contribution of dividends and cash flows to high returns.

So what does this mean for investors? Those who believe

that inflation will rise sharply in the coming years could

put their money into real assets such as commodities, real

estate and equities. In contrast, nominal assets such as

bonds or cash should be underweighted. It is worth bear-

ing in mind, however, that commodities and hence gold

are calculated in US dollars. Euro and Swiss franc investors

must bear the exchange rate risk.

Protection against inflation is also provided by inflation-

protected bonds, which are mainly issued in US dollars

(TIPS = Treasury Inflation-Protected Securities). Thesebonds are also issued in sterling and euros, but not in

Swiss francs.

1 The same is true of other commodities

10000

1000

100

10

1

1900 19201910 1930 1940 1950 1960 1970 1980 1990 2000 2010

S&P 500 Price Return Gold price

Deflation Inflation

soft Inflation/

Deflation

Chart 7: The three periods of rising gold prices

Source: Global Financial Data, Datastream, Vontobel

Price in USD (logarithm scale)

5000

4000

3000

2000

1000

0

USD

3500.

USD

1100.

USD

1050.

1973 1978 1983 1988 1993 1998 2003 2008

S&P 500 Total Return S&P 500 Price Return Gold price

Chart 8: Equities with and without dividends compared with gold

An investor who invested 100 USD in the US equity market or in

gold at the end of 1973 would now have

Source: Global Financial Data, Datastream, Vontobel

Price chainlinked (1973 = 100)


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8

In contrast to a scenario of high inflation, some observers

are forecasting deflation. We could enter a period of de-

flation if the global economy were to drop into a double

dip recession. Although that is not our main scenario, we

investigated how individual asset classes would behave in

a period of deflation. Since 1900 there have been two ba-

sic deflationary periods in the United States (see chart 4).

The average real returns for these periods were as follows

(see chart 9):

The deflation scenario is the inverse of the inflation sce-

nario. Returns on real assets are significantly worse than

on nominal assets, as deflationary periods in the past

have regularly been linked to a recession. For investors

this means they should give preference to bonds of sover-

eign and corporate issuers. Equities and commodities, on

the other hand, should be underweighted.

Chapter 3:

How to invest during deflationary periods?

Chart 9: Real returns in deflationary periods

15%

10%

5%

0%

5%

10%

15%

CorporateBonds

Cash Gold RealEstate

TreasuryBonds

EquitiesCommo-

dities

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

Real returns p. a.

Is what happened in Japan relevant for the West?

In Japan, the last 20 years have been marked by low in-

flation at times even deflation below-average eco-

nomic growth and persistently low interest rates. This

was attributable to the bursting of the Japanese real es-

tate bubble in the 1980s. Japanese companies had mort-

gaged themselves heavily to buy large portfolios of land

and property. The dramatic collapse in real estate prices

from 1990 onwards forced them to reduce their debt and

limited their investment activity accordingly. This phase,

which is still ongoing at the present time because real es-

tate prices have not yet stabilized, is known as deleverag-

ing. Periods such as this are associated with weak overalldemand in the economy and low inflation rates.

Even an accommodative monetary policy like that pur-

sued for a long time by the Bank of Japan does not lead

to high inflation. But why is that? While the private sec-

tor is deleveraging, there is little demand for new loans.

As a result, the increase in the money supply by the cen-

tral bank does not flow into the economy and conse-

quently has no inflationary effect. This effect cannot be

inferred for the current situation in the western econo-

mies, particularly not for the US. As US real estate prices

have already begun to stabilize unlike in Japan the

deleveraging phase is only likely to last between three

and five years.2

8%

6%

4%

2%

0%

2%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

in 12 monthsRepo rate Taylor rule


Chart 10: Taylor interest rate and actual key interest rate

in the EMU

Interest rates

According to our estimates, the deflation risk is somewhat

higher in Europe than in the US. Inflation has traditionally

been lower in the eurozone than in the US due to a

stronger culture of stability in Europe. Even though Eu-

ropes monetary policy stance was also below the Taylor

interest rate in the period from 2000 to 2008 (see chart

10), the divergence was smaller than in the US. Inflation

was accordingly higher in this period than the European

Central Bank (ECB) target but lower than in the US.

In the financial and economic crisis of 2008-2009 the Tay-

lor rule likewise indicated negative key interest rates, but

there was effectively no quantitative easing by the ECB. In

the last two years the ECB has held key interest rates

above the level indicated by the Taylor rule. This was one

of the factors contributing to the sluggish economic re-

covery in the eurozone. While the Taylor rule currently

recommends a somewhat higher key interest rate, our

12-month forecast for the repo rate remains unchanged

and in our view continues to be appropriate.

2 See Vontobel Asset Management From the financial crisis to the debt crisis: Effects on the economy and financial markets, March 2010


9/12

9

Since fiscal policy is now being tightened in many euro-

zone countries due to the debt crisis, economic policy is

generally on the restrictive side. While our main scenario

does not foresee a return to recession and hence defla-

tion, growth will remain below-average and inflation will

rise only marginally to around 2%.


Chart 11: Switzerland: Taylor interest rate and actual key

interest rate

14%

12%

10%

8%

6%

4%

2%

0%

2%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

CHF 3 month Libor Taylor rule in 12 months

Interest rates

Virtuous Switzerland

Switzerland has followed the Taylor rule most closely in

the last ten years. In the financial crisis the Swiss Nation-

al Bank (SNB) also practised quantitative easing, as the

negative Taylor interest rate indicated.

Switzerlands key interest rate is currently slightly belowthe Taylor interest rate. The Taylor rule recommends

raising interest rates to 1.5% over the next 12 months,

based on our economic and inflation forecasts. We con-

tinue to expect the key interest rate to remain at 0.35%

in this period, however. This is because the strong up-

ward pressure on the Swiss franc will persist. The SNB

sees real appreciation in the Swiss franc of 3% the

same effect as an interest rate increase of 1%. To offset

the current negative effect of the strong Swiss franc, in-

terest rates may be some 1.5% lower than if the Taylor

rule were strictly applied. Both currently and in the next

12 months, Swiss monetary policy can be considered

enerally appropriate, meaning that there is no major

inflation risk in Switzerland for the foreseeable future.


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10

Chapter 4:

Summary and conclusions for investors

The correlation between money supply growth and infla-

tion has widened considerably in recent decades. The

Taylor rule is therefore a more important measure of fu-

ture inflation. It implies that central banks are currently

pursuing appropriate non-inflationary policies.

We do not expect any substantial

increase in inflation in the years ahead

In addition, the deleveraging of private households and

corporates triggered by the real estate crisis will continue

for some years. We do not expect any substantial increase

in inflation in the years ahead. However, if central banks

keep their key interest rates low for too long as meas-

ured by the Taylor rule inflation is likely to accelerate.

Investors who expect inflation in the future are well

advised to overweight real asset classes such as commo-

dities, real estate and equities. If their take on the future

is more one of deflation, then sovereign and corporate

bonds should be favoured. Our analysis of inflationaryperiods shows, however, that the performance of asset

classes is not homogeneous. Although equities generally

provide good real returns in inflationary phases, they per-

form less well in the years with the very highest inflation

rates. Based on this reasoning we would recommend a

differentiated approach rather than a pure buy-and-hold

strategy for inflationary and deflationary periods. Inves-

tors therefore may have no other option than to make

tactical asset allocation decisions themselves or to dele-

gate them to a professional asset manager.


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Disclaimer

Although Vontobel Group believes that the information provided in this document is based on reliable sources, it cannot

assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this report.

This document is for information purposes only and nothing contained in this document should constitute a solicitation, or

offer, or recommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal

act of any kind whatsoever.

This document has been produced by the organizational unit Asset Management of Bank Vontobel AG. It is explicitly notthe result of a financial analysis and therefore the Directives on the Independence of Financial Research of the Swiss

Bankers Association is not applicable. All estimates and opinions expressed in this brochure are the authors and reflect the

estimates and opinions of Bank Vontobel. No part of this material may be reproduced or duplicated in any form, by any

means, or redistributed, without acknowledgement of source and prior written consent from Bank Vontobel AG.


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www.vontobel.com

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Telephone +41 (0)58 283 71 11

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Telephone +39 02 6367 3411

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Telephone +352 26 34 74 1

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New York, NY 10036, USATelephone +1 212 415 70 00

Telefax +1 212 415 70 87

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Telephone +852 3655 3990

Telefax +852 3655 3970

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