After the recent deflation scare, inflation expectations have normalised (see chart below of UK 10 year breakeven inflation). Nonetheless, the 'inflation-deflation' debate continues. Indeed, inflationistas such as Marc "Dr Doom" Faber would have us believe that the US is headed towards Zimbabwe-style hyperinflation!
However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.
Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.
Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!
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