Although falling oil prices have sent headline inflation toward negative territory in many parts of the world for the short term, this is a classic example of a non-persistent move in inflation. In other words, the type that policymakers are meant to ignore inmost cases.
Falling oil prices, reduced long-term interest rates, and easier global policy at a time of accelerating global growth is a mix of factors that should help to cut spare capacity and boost inflation over time – not diminish it. The latest version of the deflation view is that U.S. dollar strength will cause U.S. import prices to collapse, lead to very low inflation, and prevent the Fed from lifting rates.
But the U.S. is more closed than other major economies. History suggests goods price deflation can easily be offset by services inflation. And while the dollar may wreak havoc on corporate earnings, we are not convinced that U.S. firms' hiring and domestic investment plans are closely linked to the dollar value of their overseas earnings. We regard the slowdown in the energy sector and its potential to push the ISM manufacturing index lower in the near term as a bigger threat to markets and to the possibility of a Fed hike in September or (in our view) June.
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Meanwhile, in Europe, the very strong recovery in retail sales in the past six months is a reason for confidence that a descent into persistent deflation is not so likely. Couple that with signs of life in credit growth, a much weaker currency, extremely low real interest rates, and a rising equity market, and the recent deflation fears begin to look paranoid.
However, a caveat: global industrial production (IP) growth is set to slow in the months ahead, with only the euro area likely to buck the trend of falling momentum between January and the summer. Does this mean growth risks will now limit the potential for riskappetite and yields to rise?
Maybe not. Deflation fears have been so strong that global IP growth has been negatively correlated with risk appetite and interest rates since the end of last summer. This is not normally the case, but it's not unprecedented either. A six month period of a sharply negative correlation historically has occurred every few years. In between,correlations tend to go strongly positive. Since 2010, for example, the correlation on monthly U.S. 10-year yield and global IP momentum data has been 0.68, despite the -0.73 6-month correlation in January!
In our view risk appetite is being driven by rebounding confidence in European growth, so slipping global growth may not be a big deal as long as a severe slump does not occur. We do not expect sharply weaker growth or a financial stability event in the months ahead, but either could block a June Fed hike. The correlation between global growth and markets should eventually reassert itself, but for now markets must unprice deflation mania.