FEATURE

INFLATION, SLUGGISH GROWTH,

DISCO AND FLARES: WILL THESE
DEFINE THE NEXT DECADE?
By Thomas Aubrey, Managing Director – Fitch Solutions

The contents of this article are not indicative of the opinions, commentaries or analyses of Fitch’s
rating analysts, and are therefore separate and distinct from rating analyst activity, actions and
opinions. Nothing in this commentary is a recommendation to buy, sell or hold any security.

The steepening of the US yield curve over the last 12 months has led a number of market participants
to argue that a period of higher inflation is on the way, due to the recent loose monetary policy outlook.
Central bankers, however, remain concerned about deflation and hence have not begun the tightening
cycle yet. So who is right? Is the USA on the brink of a Japanese-style deflationary cycle or on the cusp
of a 1970s’ period of stagflation? For both bond and equity investors, understanding the future direction
of prices and growth will be one of the major challenges for 2010.

Comparison of
steepness of US
yield curve

1ST QUARTER 2010 © THOMSON REUTERS 2010 

 Before trying to make some sense of this conundrum, it is worth highlighting two of the main triggers of
deflation which cause economies to spiral down:

1. A dramatic fall in aggregate demand following an asset price bubble

2. A banking crisis which disrupts the supply of money

After the Lehman bankruptcy, the world’s central bankers implemented a series of policies to prevent
a broader banking crisis occurring. The implied default rates from the credit default swap market for
banks have fallen significantly from all-time highs in May 2009, highlighting the relative success of
these policies. Implied default rates fell by a factor of five from 43% in May 2009 to 9% in January 2010
at the five-year point.

Implied default rates

from Fitch Solutions
CDS Bank Indices

Implied default rate

falls dramatically

However, despite the continued improving situation surrounding the health of the global financial
system, central bankers are still concerned that worsening unemployment and sluggish growth might
lead to deflation, and hence continue to maintain a loose monetary policy outlook. But is this concern
overdone, and is it just creating the conditions for a period of stagflation?

One of the difficulties in trying to maintain stable price levels, is to understand the divergence of
actual and potential GDP and its impact on future inflation. Given the ever-changing macroeconomic
environment, being able to estimate GDP potential with a high degree of confidence is challenging at
the best of times. However, there are other approaches that might highlight imbalances between the
nominal rate of interest and potential output, which investors might use to their advantage.

One such approach is to use the theoretical framework provided by the Swedish economist Knut
Wicksell, which heavily influenced the Austrian business cycle theory of von Mises and Hayek. Wicksell
argued that there are two rates of interest: the money rate of interest and the natural rate of interest.
The natural rate of interest is equivalent to the return on capital for a good or a service. When the
money rate of interest is artificially lowered by central banks or when the natural rate of interest
increases due to some productivity enhancement, it creates incentives for increased investment. As the
difference between the two rates is the entrepreneurs’ profit, it sets off an investment binge, increasing
consumption and output. However over time, the economy becomes imbalanced, and for equilibrium
to return, there needs to be a period of lower consumption and output as the savings rate starts to rise
before the next cycle starts.

1ST QUARTER 2010 © THOMSON REUTERS 2010 

 So what can this tell us about future price levels? This clearly depends on what impact the fall in
aggregate demand is going to have on the economy. Either companies start to reduce prices in order
to generate some return on fixed capital, potentially leading to a deflationary spiral, or they might
cut capacity significantly in order to ensure price levels are less impacted for their goods, leading to
inflation once demand starts to pick up again. It is here we see three distinct differences between Japan
and the USA, suggesting that the USA is far less exposed to a period of deflation than Japan was in
the 1990s. The differences include: 1) the level of investment as a portion of GDP; 2) the implied default
rates from the credit default swap market; 3) the real return on invested capital.

The chart below shows that Japanese private-sector investment as a percentage of GDP has been
consistently higher than in the USA over the last 30 years. Indeed, on average it was 1.73 times higher
over the period. Such high levels of over-investment make it harder for companies to adjust to lower
levels of aggregate demand, causing price deflation given the higher levels of aggregate supply.

Private investment as
a percentage of GDP:
Japan vs USA

Furthermore, a comparison of the Fitch Solutions Total Market CDS Indices for USA and Japan since
2003 shows that the market has persistently implied lower default rates for Japan. Indeed, the USA
has on average had a 3.3 times higher implied default rate than Japan over the period. This matters
because higher default rates allow an economy to adjust to lower aggregate demand much more
quickly. Although this leads to higher unemployment, the faster reduction in aggregate supply allows
price levels to adjust so that there is less deflationary pressure, unless unemployment spirals out of
control. In recent months there has been a narrowing of the gap between the two markets, mainly
driven by the bankruptcy of JAL rather than any shift in US economic policy. However, it is too early to
argue that Japan is set on a new course of permanently higher default rates.

1ST QUARTER 2010 © THOMSON REUTERS 2010 

 Fitch Solutions CDS
Total Market Indices:
USA vs Japan

The final piece of evidence is to compare the aggregate real returns on capital between Japan and the
USA over the last 30 years. The first thing to note is that the real return on capital for Japan was only
about 2% for much of the 1990s, despite investment levels as a percentage of GDP being considerably
higher than in the USA. Secondly, it highlights the relative efficiency of US listed companies to utilize
capital more effectively. Even in 2008, the real returns were about 7%, as companies began to cut
costs to adjust to the new lower level of aggregate supply, thus shoring up their profit margins vs only
5% in Japan.

Real returns
on capital:
Japan vs USA

As for 2009 and 2010 corporate earnings, the I/B/E/S consensus rate of growth of earnings per share
(EPS) is forecast to increase, reflecting an expected rise in global aggregate demand. Both Japanese
and US companies are showing increases in expected EPS growth, with Japan’s growth rates being that
much higher because of the much higher fall-off in EPS last year. Given EPS growth is highly correlated
to the Return On Invested Capital (ROIC), we can expect the ROIC to increase once more.

1ST QUARTER 2010 © THOMSON REUTERS 2010 

 EPS YOY GROWTH USA JAPAN
2006-2007 2.9% 1.8% ACTUAL
2007-2008 -31% -116% ACTUAL
2008-2009 1.4% 304% FORECAST
2009-2010 27% 86% FORECAST

So what does this mean for inflation in the USA and Japan? If we return to Wicksell’s framework and
graph the relationship between the money rate of interest and the natural rate of interest, we can see
a number of things. Firstly, it is clear that one of the major drivers of Japanese deflation was the raising
of the money rate of interest above the natural rate of interest for a five-year period. This had a massive
impact on depressing the economy, leading to the “lost decade”. So how does the chart help explain
why Japan is still deflating when the difference between the two lines should be inflationary? Although
the difference between the money rate and natural rate started to widen from 2005, leading to the re-
inflation of the economy, the consequent drop in aggregate global demand with the onset of the credit
crisis sent prices in Japan back on a downward spiral. Again, the lower default rates, higher investment
rates and lower return on capital constrained the Japanese economy from reducing capacity. Given
global aggregate demand is unlikely to return to pre-crisis levels for some years, prices in the Japanese
economy may remain depressed for some time, as interest rates are almost zero, which is exacerbated
by the lack of flexibility in the economy to reduce aggregate supply.

As for the USA, the analysis suggests that the prognosis is rather different. Firstly, the current rate of
year-on-year inflation is now positive. Moreover, the difference between the money rate of interest and
the natural rate of interest is still significant and is likely to increase, given the bounce back in EPS
growth forecasts.

Differential between
money and natural rate of
interest: USA and Japan

1ST QUARTER 2010 © THOMSON REUTERS 2010 

 In conclusion, the Austrian School’s approach to understanding the business cycle highlights the
increased probability of accelerating inflation for the United States. Firstly, there have not been the
levels of over-investment as seen in Japan. Secondly, corporations have been very adept at adjusting
to the new lower levels of aggregate demand including higher defaults, thus placing less downward
pressure on prices. Indeed, the fact that returns on capital have maintained themselves through the
crisis shows how well USA Inc has been able to adjust to the downturn. Finally, the difference between
the money rate of interest and the natural rate of interest is likely to lead to investment levels beginning
to increase, albeit slowly. If inflation starts to grow above reasonable expectation levels, central bankers
may be forced to raise the money rate of interest. Given the process of consumer deleveraging has
not fully worked its way out of the system, growth expectations may start to fall. The combination of
higher inflation and lower growth, or stagflation, may therefore return to haunt the economy until the
deleveraging process has completed. As far as a return to 1970s’ disco music and flared trousers goes,
this certainly remains a larger unknown.

Further reading
Preventing Deflation: Lessons from Japan’s experience in the 1990s, International Finance Discussion
Papers, Ahearne, Gagnon, Haltmaier, Kamin et al, Board of Governors of the Federal Reserve System, No
279, June 2002.
The Real Interest Gap as an Inflation Indicator, Neiss K, Nelson E, Bank of England, October 2000.
Interest and Prices, Woodford M, 2003.
Measuring the Natural Rate of Interest, Laubach T, Williams J, Board of Governors of the Federal Reserve
System, November 2001.

1ST QUARTER 2010 © THOMSON REUTERS 2010