Sometimes it takes a crisis to make us all realize that, yes, inflation can always be lurking just over the horizon.
We certainly can't depend on how the markets have responded to economic signals about the potential for the coming onset of inflationary clouds. Just a short while ago, when many indicators across G-7 economies would have indicated that policy should be tightening to head off inflation, the markets uttered a resounding “meh” to the prospect. Then came a new crisis in Iraq, which only followed on the heels of the crisis in the Ukraine, all preceded by the never-ending crisis in Syria, which is now possibly merging with the crisis in Iraq, and so on.
What we're looking at is a classic non-consensual picture: the vivid contrast between reaction to economic signals and the prospects for inflation as driven by crisis. For investors, that's an opportunity. The case could be made that this is the best time to take out “insurance” against inflation through real-return strategies, in fixed income and elsewhere. The strong market-implied consensus for very low inflation makes such insurance inexpensive. For investors looking to reduce risk after the runup of equities in their portfolios, considering such inflation insurance could well be an attractive proposition.
The threats to the world are real. Iraqi oil is exported globally. Europe in particular is highly dependent upon gas at least supplied through Ukraine. The recent Sino-Russian oil deal gives protection to Russia's energy revenues and makes it less dependent upon the West, which is struggling to impose meaningful sanctions upon Russia. In previous crises in energy-producing countries, a spike in oil prices and a rise in inflation expectations would be de rigueur, yet there is little sign of this in 2014. Of course, the increased level of energy production in the US due to the shale gas boom is lessening the effects of such geo-political instability on the oil price.
From a macroeconomic perspective, the U.S. economy is growing steadily and unemployment has fallen more quickly than most had expected. The same can be said in the U.K., possibly even more so. Europe remains a drag, with structural inefficiencies left from the as yet not finally resolved euro crisis, but Germany, the main powerhouse, is still growing healthily.
Inflation has clearly not arrived yet. While this is unsurprising in Europe, the U.S. has also followed this trend. The chart below shows the year-on-year rise in the U.S. consumer price index along with a "surprise index"which rises by one every time inflation is higher than market expectations, and drops by one when it is lower. We can see a precipitous fall in the surprise index through 2012-'13, along with a declining inflation rate.