We are probably at the tail-end of the Great Recession that followed the GFC, but the environment is far from ‘normal’. The outlook remains highly uncertain and inflation prospects are perhaps the area in which opinion is the most divided.

Inflation expectations are no longer huddled around an assumption of a benign inflationary outcome, as they had been for many years. Instead forecasts are unusually skewed towards two extremes: prolonged deflation or uncomfortably higher inflation.
But this is not just an academic argument. The medium to longer term inflation outcomes will have profound impacts on economic policy, the world economy, and asset prices.

What the textbooks say
In the textbooks, inflation is generated primarily from two sources. Demand pull (where an increased desire for goods and services is greater than the supply) and cost push (where increased costs in the production process flow into higher prices).
In practice, the two types tend to be interrelated. Higher demand that outstrips available supply also increases the demand for, and price of, a range of production inputs including, most notably labour.
Although a simplification, economists’ views of the causes of inflation can be categorised into two broad schools. Monetarists believe inflation is always a monetary phenomenon relating to the supply of money in an economy. Monetarists argue that all inflation is essentially demand-pull, caused by too much money chasing too few goods and services. Conversely, deflation is the result of an inadequate supply of money. Monetarists are likely to express concern at the massive liquidity injections into the financial system and the monetisation of debt – particularly in the US and UK – that are being used by governments to stimulate their economies.
In contrast, although a Keynesian would agree that excessive money supply growth can cause inflation, they would emphasise that it is fundamentally caused by excessive demand for goods and services relative to the economy’s ability to supply them. Excessive money supply can cause inflation but only if that money finds its way, through the financial system, into the real economy. A Keynesian would equally argue however that a range of factors can cause demand to accelerate relative to supply. Right now, worrying about inflation would be well down a Keynesian’s list of priorities. Our Keynesian would stress that demand remains extremely weak, that fiscal deficits are a necessary by-product of governments’ efforts to bolster the economy, and that the massive injections of liquidity have not yet found their way into the real economy.

The reality
As things stand, the massive injections of liquidity by central banks have not yet resulted in significant increases in credit growth, as this liquidity has been used to repair bank balance sheets rather than expand credit.
As a consequence, we have yet to see meaningful improvements in private sector spending, nor any acceleration in inflation. However that is not to say neither will occur. The lags involved are famously long and variable.
But for the time being, excess aggregate demand is all but absent and the global economy continues to experience sub-par growth.

The role of expectations
In practice inflation is generated not only from demand versus supply, but also by the expectation of future inflation. Expectations of higher inflation can be self-fulfilling, when those expectations become factored in to wage demands and price setting decisions.
While deflation remains a threat, particularly in the near term, stimulatory policies remain in place for much of the global economy. The depth of the recession means the threat of inflation is likely to be some way off too. However, the current emergency measures will have to be reigned in at some point, in order to prevent an inflationary outcome. And it could equally be argued that governments, now laden with so much debt, have an incentive to inflate their way out of it.
Despite the best efforts of forecasters, future inflation outcomes are essentially unknowable. Credible arguments exist for both inflation and deflation over the medium to longer term, and indeed within MLC views on the inflation outlook remain mixed.
In light of this, investors would be well-advised to diversify their investment strategy to protect against both a deflationary and/or an inflationary outcome!

Kerry Napper is an investment analyst for MLC

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Your definition of Inflation is wrong
written by Sceptic of Investment Analysts, December 01, 2009

Inflation - is defined as the increase in the supply of money. An increase in the money supply doesn't CAUSE inflation. An increase in money supply IS inflation.

Therefore, with central bankers printing money from thin air at the rate of trillions, we are left in a state of huge inflationary pressures. Just because "asset" prices fall doesn't mean there isn't inflation.

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