財經觀察 1531 --- The deflation bubble

Short View: The deflation bubble

Published: November 17 2008 18:36

Many investment bubbles have deflated in the past 18 months. Could a bubble in expectations of deflation itself need to deflate before long?

Bond yields are low for understandable reasons. With investors fleeing risky assets, it is no surprise that they are buying bonds. Financial stocks, in the US and globally, are plumbing new lows, showing concern about financial activity. The ongoing collapse in commodity prices virtually guarantees that inflation is vanquished for the short-term.

But has this been taken too far? The expectation for average US inflation over the next five years, derived by comparing the yield on nominal bonds with the yield on inflation-linked bonds (known as Tips), is minus 0.5 per cent. In other words, if there is any inflation at all in the US over the next five years, Tips will generate a better return than nominal bonds.

The "break-even" level for five-year inflation had been steady at between 2 and 3 per cent for years before the market suddenly became convinced of the case for deflation back in September.

This suggests a historic shift in the economy. The last time US prices were on average lower than in the previous year was in 1955. This was an isolated "one-off". From 1927 to 1933, prices deflated six years out of seven, falling by more than 9 per cent in 1931 and 1932. So the market is braced for worse than anything since the Depression - albeit healthier than the worst years of the early 1930s.

But the early 1930s did not see aggressive moves by governments to inflate the economy out of trouble, as we have seen this year. Bond issuance will have to rise to pay for the fiscal stimulus packages now mooted, pushing up yields.

If this sounds like a recipe for resurgent inflation in a few years' time, it is at least reassuring that insuring against inflation is now so cheap.

Copyright The Financial Times Limited 2008