A deflation scare will grip the developed world over the next 12-24 months

Heading For Deflation?

A deflation scare will grip the developed world over the next 12-24 months.

Our research on past real estate bear markets and subsequent banking sector stress (throughout Europe, the U.S. and Japan) highlights that these episodes always lead to a recession, followed by a multi-year period of sub-par growth (i.e. negative output gap). In turn, excess supply helps dramatically drive down core CPI inflation in the years that follow. Granted, it could be argued that the previous episodes occurred during a period of strong structural disinflationary trends, thereby amplifying the magnitude and duration of the decline in price pressures. Nonetheless, core CPI inflation is likely to drop sharply throughout the G7 over the next 12-24 months, to lows at least comparable to the 2003 deflation scare. In turn, it is likely that the U.S. prints very low positive or even mildly negative headline CPI numbers, given the drag resulting from the recent plunge in food and energy prices. Headline inflation is less likely to turn negative in Europe given the rigidity of the price structure but a deflation scare similar to the U.S. earlier this decade is likely. The implication is that policymakers will continue to ease aggressively and then stay on hold for an extended period, benefiting our long duration call. While the longer-term consequences of such actions may be inflationary, government bond yields will adjust lower in the near term.

source:http://www.bcaresearch.com/public/story.asp?pre=PRE-20081117.GIF