While 2014 has been another year of soft growth and low inflation, the big story for 2015 is inflation or, more precisely, the lack thereof, a report said.

The low inflation-high liquidity story is far from over, added the recent report "Global Economic 2015 Year Ahead  – “Inflation, disinflation, deflation” from Bank of America (BofA) Merrill Lynch Global Research.

Growth has been modestly weaker than expected in most regions in 2014, said the report.

“The timing of the weakness has varied across regions: the US started with a terrible first quarter, but has been solid ever since; by contrast, many other countries started out solid but have weakened recently. As expected, inflation has remained soft by historical standards. The big story next year is not the Fed exit, the ECB adopting QE, China’s hard or soft landing or Abenomics. These are all derivatives of a deeper story: global disinflation,” the report said.

Post crisis economics

One of the clear lessons of economic history is that major banking and real estate crises cause deeper-than-normal recessions and weaker-than-normal recoveries. In the latest cycle, all the major economies have outperformed history, but the US has stood out above the others – the recession was smaller and the recovery quicker.

The outperformance of the US is likely to continue, according to BofA Merrill Lynch.

The two most damaged sectors – banking and housing – have healed significantly. Balance sheets have been repaired in almost every sector. Most important, the household sector has now reversed about three-fourths of the run-up in the debt-to-income ratio during the credit bubble, and household debt service has tumbled to the lowest point in the 35-year history of the series.

Headwinds from Washington have faded: after three years of aggressive fiscal tightening, policy has turned neutral. The adverse popular backlash against the government shutdown also seems to have refocused the political battle away from budget brinkmanship and toward the presidential election.

By contrast, the Eurozone has not fully recovered from the great recession, let alone its recent debt crisis. For Europe, muddle through is both our baseline forecast and, for the most part, a best-case scenario.

“As we discuss in more detail below, outright deflation is a major risk. Even more troubling, there are growing signs of political fragmentation, with rapid growth in populist parties in many countries,” the report said.

“Abenomics remains very much a work in progress: it is unclear whether Japan will be able to exit deflation on a sustained basis. On the one hand, the BoJ has acted forcefully in helping weaken the currency, strengthen the stock market and boost confidence. On the other hand, fiscal authorities have unnecessarily threatened the recovery with a sharp 3pp consumption tax increase and there has been very little progress on the reform front. As this report goes to press, it appears that a snap election might do the trick in helping the government to avoid another sharp tax hike and get the reform process off the ground.”

In emerging markets, China has been the center of attention, with several bouts of weak data in the past year. However, with low inflation, BofA Merrill Lynch expects the government to do what it takes to restore normal growth.

Inflation: low or too low?

The Great Recession left large output gaps across the world. Solid growth in 2010 and 2011 closed some of the gaps, particularly in emerging markets, but since then, growth has fallen below trend, causing the gaps to rewiden slightly.

“In our view, official estimates of these gaps are probably too high, but even with aggressive haircuts there is plenty of spare capacity. Adding to the downward pressure, it appears that commodity supply has now caught up to and passed commodity demand, lowering headline inflation. As with growth, there is considerable variation across regions. For the US, we expect ongoing imported disinflation to be offset by a modest pick-up in wage growth leaving core inflation flat at about 1.5 per cent,” the report said.

“By contrast, inflation is likely to linger near zero in the Eurozone. Economists in Europe are remarkably sanguine about the risk of deflation: the ECB’s latest survey of professional forecasters sees a tiny 4.3 per cent chance of deflation next year and an even lower 2.3 per cent chance in 2016. By contrast we would peg the risk at one in three. Meanwhile, it remains unclear whether Japan will exit from deflation on a sustained basis.”

Policy: QE rotation

“Continued output gaps and weak inflation give central banks plenty of room to ease policy. In EM we expect a mix of small rate hikes and cuts. By contrast, we expect balance sheet expansion for the big four central banks including the Bank of England) to be faster in the year ahead than it has averaged over the last five years.

“We expect both the Fed and BOE to keep their balance sheets flat and not hike rates until the second half of the year. In the Eurozone we expect inflation to remain persistently below the ECB’s forecasts, triggering the usual slow-footed response from the ECB. We also expect the BoJ to continue its aggressive balance sheet expansion, both in terms of size and in branching out into more risk assets,” BofA Merrill Lynch said.

Risks: normal now, high later

“In the near term we think the risks to global growth are relatively balanced; however, several risks rise in the years ahead. First and foremost, while Europe is likely to muddle through in the short term, we worry that if outright deflation develops, markets could refocus on Europe’s dismal debt dynamics,” BofA said.

“This would be particularly problematic if markets lose faith in the simulative powers of the ECB. An even bigger risk is that chronic weak economic performance causes a populist party to take power in a key country and triggers a crisis of confidence in markets. On a similar note, the Chinese government seems ready and willing to avoid a hard landing in the short term. However, longer term the country faces major challenges in curbing corruption, getting debt growth under control and shifting toward a more balanced economy.

“Finally, we worry about what happens to Japan if Abenomics fails to restore healthy nominal GDP growth. Japan’s debt dynamics are very poor, with huge initial debts and a rapidly aging population. In our view, all of the ‘arrows’ have to be on target to avoid an eventual crisis.” – TradeArabia News Service