Six years after the global financial crisis hit growth across much of the developed world, you might think we have finally embarked on a path of steady healing. Unemployment rates are falling, growth is positive, albeit a little disappointing, and financial markets, for the most part, exude confidence.
But problems remain. Debt, for example, is stubbornly high and has grown sharply in many emerging markets. Even more troubling is the slowdown in inflation across the world, which poses renewed risks to financial stability.
In the West, inflation has continued to lose steam in recent years. Despite unprecedented monetary easing and a gradually tightening labor market, price pressures in the U.S. have fallen close to multidecade lows. In the eurozone, inflation is now stuck well below 1%, confounding the European Central Bank's expectation of a gradual acceleration towards its target of almost 2%. Last month, the head of Germany's central bank, among the most conservative in the world, conceded that more easing may have to be applied to prevent outright deflation.
What's new is that even in emerging markets, including those in Asia, price pressures are tumbling. Take China. Producer prices have already fallen for 24 months. Consumer prices, too, have trended lower, with the 2% rise in February coming in well below the government's forecast of 3.5% for this year. Inflation remains muted elsewhere too, from South Korea to Taiwan, and Malaysia to Thailand. Even in India and Indonesia, prices have not spiked as much as feared, given the sharp depreciation of the two countries' currencies over the past year.
Stuck in the past
The mantra over the last three decades has been that inflation needs to be brought down at all cost. Scarred by the experience of stagflation in the 1970s, central banks applied rigorous inflation targets that often took precedence over other goals like full employment. However, such one-sided thinking ignored the risks posed by excessively low inflation, let alone deflation. Especially with debt levels climbing, falling price pressures can pose challenges to financial stability as credit becomes harder to service.
In emerging Asia, including China, profit margins among listed companies are at a decade low. A lack of pricing power explains much of this, with excess capacity and a lack of global demand forcing companies to cut prices. The cost of traded manufactured goods has fallen from its peak in 2008, putting further pressure on exporters. Domestically, price controls and fierce competition have added to the pain.
The world needs to learn from Japan's experience with deflation. Once shrugged off as a phenomenon unique to the country, the world is now at risk of stumbling into a similar trap. Falling prices prompted a vicious spiral of decreasing profits, declining wages and stagnating prosperity. Japan, however, was lucky in that its wealth allowed it to avoid a bigger calamity, with the government being able to forestall a collapse through continuous pump priming. Without it, Japan may have seen its economy slide into an outright depression.
What's causing the sudden bout of disinflation across much of the West and in emerging markets? At heart, there is an imbalance between supply and demand. The latter may appear especially puzzling given that interest rates are near record lows and emerging markets are adding an unprecedented number of new consumers to the world economy. Look closely, however, and it quickly becomes apparent that rising income inequality, in both the East and the West, explains much of the lack of demand.
For decades, wealth has accrued faster at the top than at the bottom. Since the rich save proportionately more than they consume, the world is deprived of additional demand. What's more, the growing pool of savings is holding interest rates down and encourages over-investment. For a while, especially in the West, stagnating wages for the bulk of the population were masked by a boom in household credit, allowing consumers to splurge without a corresponding rise in income. That is no longer the case.
In the East, too, there has been a sharp rise in income inequality in recent years. This is often dismissed as an inevitable byproduct of rapid economic growth. But that is not the whole story. The absence of comprehensive social security systems and insufficient income growth among households has generally restrained demand even in Asia. As a result, consumption as a share of gross domestic product has barely risen in most economies, while surging investment keeps adding to supply.
The risk that slowing inflation poses to the world economy is becoming increasingly clear. As a result, monetary policy will remain extraordinarily loose for quite some time. But this, in itself, will not fix the problem. Income needs to be divided more evenly for demand to pick up. This is not a call for socialist redistribution. But there must be a middle way that allows the gap to narrow over time. If not, the world will drift into deflation, with dire consequences for both rich and poor.
Frederic Neumann is co-head of Asian economic research at HSBC.