Growth and benign inflation a potent mix

Subdued inflation and signs of economic growth proved a powerful tonic for the equity market today after the previous evenings wobble. It would appear that after today's rise in the FTSE 100 that the index is poised to break through the 6400-6800 trading range of the past 6 months. The move the other evening that saw the US market fall over 1.5% in a few hours was to say the least odd. With the growth of electronic trading these ‘flash crashes’ are likely to become more prevalent.

Yesterday's UK inflation data was good news for the consumer. It does now mean this year, if inflation stays at these levels, that the UK economy should see real economic growth. What is surprising, to many, is how inflation is so benign considering the amount of liquidity being pushed into the global economy. It is not just benign in the UK but also Europe, and the US. Currently, it would appear the monetary policies of the central banks are working well. The question to me is where is all this liquidity going, and why is it not leading to higher inflation data as many assumed? Proper inflation is caused by economic growth, leading to more employment, tighter labour markets forcing higher wages. This is why central bankers like Mark Carey link employment and monetary policy. Inflation spiralled out of control in the 1970s as many public sector workers received large pay increases after the shock rise in the oil price, caused by the Middle East crisis. The problem in the 1970s was that higher wages were not being accompanied by higher productivity.

With the world such an indebted place Central banks cannot allow deflation to occur, effectively increasing the value of debt. They also don’t want inflation without economic growth. It is a difficult balancing act but at present they seem to be doing a pretty good job. With inflation being so benign one does have to wonder a little how much of the central bank's liquidity is going into the real economy and how much is going into risk assets. This why some market analysts constantly worry that the withdrawal of the liquidity will lead to a re-pricing of risk assets. If inflation is subdued with all this liquidity, one also has to wonder what the world would be like without it? But for today at least things seem to be ticking along ok.

Posted on January 15, 2014 .