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Société Générale Inflation to ease the debt burden Special Edition May 2009

Société Générale Inflation to ease the debt burden Special Edition May 2009

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 Eco-InsightSpecial edition
 
28 May 2009
 
Inflation to ease the debt burden
 
Véronique Riches-Flores
(33) 1 42 13 84 04
veronique.riches-flores@sgcib.com
Please see importantdisclosures at the end of thedocument
 
What message are markets giving us?
Inflation expectations have changed radically.Between end-December 2008 and end-May 2009, US long-term inflation expectations literallytook off, chalking up the greatest surge ever seen over a comparable period. The yield on 10-year government bonds gained more than 100 bp, despite the implementation of the Fed
sbuyback plan. All told, the 10-30-year segment of the yield curve steepened by 100 basispoints.
 
No, inflation is not just around the corner.
Short term, world inflation will turn negative atleast for a few months, until the energy-price-related base effect falls out of the numbers.Thereafter, the anticipated pick-up in unemployment and persistently weak productioncapacity utilisation worldwide will stand in the way of a spontaneous uptick in inflation.
 
However,
markets are looking beyond the next couple of months
. Indeed, we consider thatchanges in expectations could well reflect more structural factors: 1) exceptional economicpolicy responses to the current crisis provide fertile ground for an eventual return of inflation;2) by recovering the reins of financial and economic regulation, governments have giventhemselves powers relinquished long ago and considerably increased the weight of the non-competitive sector in the economy; 3) industrialised economies will be unable to get rid ofexcessive debt levels without help from inflation.
 
The probability of an inflationary exit to the current crisis has definitely increased.
Inflationappears to be the only way to address the issue of excessive debt. As a substitute forinsufficient growth in real wages, inflation can remove the debt burden while at the same timemaintaining viable economic conditions. Cruelly efficient, inflation of only 3% p.a. wouldautomatically send debt ratios down by one quarter over ten years, assuming growth in debtdoes not outstrip that of real GDP. With inflation at 4%, the stock of debt would be reducedby a third over an equivalent period.
 
Inflation: when, and what will the impact be?
 After 20 years of global disinflation, the rangeof tools available to economists to predict the exact timing of a return of inflation have been jeopardised. Identifying the return of inflation
will thus require us to proceed in baby steps,attentively observing economic developments over the coming quarters:
H2 09, when the globaleconomy recovers, will be the test, as we should then obtain more hints as to the timing of areturn of inflation.
 
Far from representing a panacea, the inflation option is more of a necessary evil
in aneconomic context that has been pushed out of balance by the excessive borrowing of recentyears. Blocking such an option would force industrialised economies to accept a painfuldeleveraging process that would carry an unsustainable cost.
INFLATION – part oneThe basis of the debate
The aim of this document is topresent the groundwork for reflection on the currentinflation backdrop. A key topic for years to come,our discussion will becomplemented bycontributions from our variousresearch teams.
 
Inflation to ease the debt burden
28 May 2009
Contents
14
19
21
Tables index Charts index
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3
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SG inflation forecasts: US
21
SG inflation forecasts: Eurozone
 23
ECB equilibrium rate
24
100 day changes in US implied inflation (end-Dec 2008 to mid-May 2009)
24
US Treasury yield curve, 10-30 yrs
 25
Sensitivity of US long-term rates model to inflation scenario
26
Impact of 4% inflation on public and private sector debt in 15 years - % ofGDP
26
Shortfall in annual growth from a debt reduction equivalent to the impactproduced by 4% inflation over four years
 
Inflation to ease the debt burden
28 May 2009
 3
 
Inflation: why the concern?
Should we anticipate a return of inflation? Well, the jury is still out! After several months ofdiscussion on the subject between economists, strategists and investors, sceptics use anumber of strong and convincing arguments.
 
The strength of underlying economic trends.
 Against the current backdrop and withexpectations for the upcoming quarters unlikely to change dramatically, it is difficult to seehow to kick-start a bout of inflation: wealth destruction, tight credit, spiralling unemployment,worldwide under-utilisation of production capacities, a cyclical rebound in productivity,expectations of further fiscal rigour to come
all these factors suggest that, at present, weare more likely to see an intensification of downward pressure on prices. Indeed, our forecastsare unequivocal, pointing to underlying inflation of less than 1% on a 12-month horizon bothfor the US and the Eurozone.
 
The difficulties of inducing a pick-up in inflation in a global world
seeking the lowest labourcosts possible, and when an even more abundant supply of such labour is likely after thecurrent crisis. Lack of employment, a key concern for the global economy overall, will be amajor factor in exerting downward pressure on production costs. The current crisis couldactually intensify wage competition which has been at the root of the trend towards globaldisinflation over the past 15 years.
 
Money creation is currently non-inflationary as money has not gone into circulation
. Theexpansion of central bank balance sheets has had a limited impact on the liquidity ofeconomies, as the resulting flows have mainly come back to central banks in the form of bankdeposits, as borne out by the very weak growth of monetary aggregates. However, the issueis how the central banks could withdraw this liquidity once the banking system has returned toa firmer footing.
 
A central bank dam against inflation.
For three decades, central banks have successfullymanaging kept a lid on inflation and
de facto
the ECB cannot stray from its mandate ofensuring price stability.
 
Finally, the belief that inflation cannot be decreed
, as we learned from the Japaneseexperience of the 1980s and beyond.
The impossibility of a return of inflation
Inflation breakeven - 10 yr
US Implied inflation rates
05200806 07 08 09 10 11 12 01200902 03 04 05 060.00.51.01.52.02.53.0
ShrinkingcreditFallingcapitalisationInflationcollapsingIndustrydownsizingNegative wealtheffectsDebt de-leveraging
 
Growing outputandemploymentgaps
 
Source : SG Economic Research

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