The initial plunge drove year-on-year inflation rates down to extremely low and even negative levels across the developed world (see chart below). The residual high inflation observed in some emerging countries was due either to specific issues, such as food prices in China and price controls in Brazil, or to heavy currency depreciation.
Now, however, consumer price indices are bouncing back in most countries and these increases could gain pace in the coming quarters. The US and the Euro Zone are no exceptions, for two main reasons. To begin with their growth rates are on trend and even above, reflecting a neutral to positive output gap that ultimately results in gradual upside pressure on core inflation. Secondly energy prices, which alone drove headline inflation down 2% in US and down 1% in the Euro Zone, will soon send these rates back up again by 1% and 0.5% respectively (see left-hand chart below). This movement will peak in February 2017, with headline inflation reaching 3% in the US.
The disinflationary environment brought about by the contraction in energy prices created a wealth effect in countries that are net importers of oil and gas. On the other hand the rally seen since February is increasing their energy bill, reducing consumers' purchasing power and eating into cash flows that companies could otherwise use for capital investment. Global economic growth will inevitably be hurt, even though it is set to rise in the second half of 2016 thanks to fiscal stimulus and monetary easing outside the US.
After first of all worrying about deflation early this year, investors could be temporarily alarmed by the pace of price increases, generating volatility in the markets. Expectations of further interest rate hikes by the US Federal Reserve are too low, as are inflation expectations generally.
The swaps market has priced in just one increase of 25 basis points in the US federal funds rate this year, compared with two in our own scenario. The break-even rates for 10-year swaps are 1.6% in the US and 1.0% in Germany. If these indicators were to shoot up more quickly or vigorously than anticipated, bond yields would surge and send returns on debt securities into negative territory. Likewise, the uncertainty generated by the helicopter money policy pursued by most central banks could push up the long end of the yield curve. Yet any such spike in yields could prove temporary. Once the February 2017 peak is over, annual headline inflation will promptly return to tame levels ranging from 1% in the Euro Zone to 2% in the US.
The impact on stockmarkets will depend on the tone of the statements that follow Fed decisions. If investors are reassured, equity benchmarks will hold up. But if investors believe the US central bank is tightening credit conditions too harshly, and that this could weaken earnings growth, valuation multiples will decline.
In the forex market the dollar will automatically appreciate each time the Fed raises short-term interest rates, even though the US currency is overvalued at present.
We should bear in mind that each new increase in oil prices will stoke concern and the related financial risks. For this reason the inflation theme will be among our uppermost economic and strategic preoccupations as we head into the second half of 2016.