Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20pc.It is a remarkable state of affairs that the G2 monetary superpowers - the US and China - should both be tightening into such a 20pc risk, though no doubt they have concluded that asset bubbles are becoming an even bigger danger."We need to be extremely vigilant," said the IMF's Christine Lagarde in Davos. "The deflation risk is what would occur if there was a shock to those economies now at low inflation rates, way below target. I don't think anyone can dispute that in the eurozone, inflation is way below target."It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.The World Bank warns in its latest report - Capital Flows and Risks in Developing Countries - that the withdrawal of stimulus by the US Federal Reserve could throw a "curve ball" at the international system.
Our cheery friend Ambrose Evans-Pritchard wrote a worthy piece on the dangers of deflation given the present economic circumstances.
Perhaps the most concise statement of our current predicament follows in this short paragraph:
Markets have a touching faith that the same Politburo responsible for a spectacular credit bubble worth $24 trillion - one and a half times larger than the US banking system - will now manage to deflate it gently with a skill that eluded the Fed in 1928, the Bank of Japan in 1990 and the Bank of England in 2007.The markets in general, most conventionally schooled investors, and the workforce in many countries will soon face some difficult choices. The same group of geniuses who inflated the bubble are now going to deflate it softly? I doubt it.
Deflationary pressures are likely to stagnate and even push down wages. Asset prices of anything that requires significant leverage are likely to fall considerably. The Canadian housing market immediately springs to mind as one of the most vulnerable globally as higher interest rates, lower credit availability, and tightening rules for high ratio mortgages reduce the number of buyers.
We have seen since late December a recovery in bullion prices and gold miners. This is one of the few refuges in a deflationary environment. With the Fed starting to take away the punch bowl, markets and investors are starting to feel the effects of a nasty hangover.
What happens next?
We shall see. Often the conditions required for deflation take longer to manifest that we expect.