Bond Outlook October 17th

Is inflation or deflation around the corner? Neither markets nor commentators (including ourselves) can pretend to know, so let us consider both sides of the argument:

• Inflation is coming, especially in the USA: oil prices are reaching new heights, as are food costs as crops are switched to “biofuel” production. The dollar is falling as foreigners reduce their holdings of assets in USD and the Americans themselves invest abroad. Chinese goods are costing more to import because of Chinese inflation (over-heating) and a slowly increasing RMB exchange rate. Despite problems in housing, manufacturing and the credit squeeze, the US consumer is declining to reduce spending.
• No, the current scenario is deflationary: the bursting of the US (and UK?) housing bubble is deflationary. No matter the action of central banks, burst asset bubbles are followed by decline or reversal in inflation because neither businesses nor households can continue spending at the same level. Globalisation allows goods and services to be produced in low-cost countries, off-setting the higher prices of crops and oil. The credit squeeze will slow expenditure by business and households alike.