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Has Goldilocks gone for good?

  • Stephanie Flanders
  • 17 Feb 09, 03:09 PM GMT

Should we be more scared of deflation - or of inflation? Anyone who's been living on planet Earth the past few weeks will choose deflation.

It's fear of falling prices that's driving policy by the Bank of England and the Federal Reserve right now. And rightly so. We saw and we don't want it here, thank you very much.

The CPI (Consumer Prices Index) measure of inflation , and the Bank of England now expects it to fall close to zero by the middle of next year. But they don't rule out the possibility of a negative CPI. And they see little chance of CPI above 2% before 2012.

The City takes a slightly different view. If you look at market measures of inflation expectations, investors seem to expect moderate deflation in the next year or so, but significant inflation after that - of the order of 3 to 4%.

But as usual, those market expectations hide a lot of disagreement. And right now, the sheer range of views on the inflation/deflation spectrum is wider than anyone can remember.

There are those who fear a Japan scenario - a decade of self-reinforcing deflation. But there are also those who think that high inflation - even hyper-inflation - is not very far off.

That's because the more successful the central banks are in preventing deflation, and in persuading us all that prices are set to rise, the greater the chance of excessive price growth down the road.

The middling, "base-case", scenario built into most city economists' economic forecasts is what the bond market is reflecting: two years of low inflation, possibly mild deflation, with a moderate uptick in inflation after that.

But then, the base-case scenario a year ago was for a modest slowdown in the advanced economies, and consistent growth everywhere else. Look how that turned out.

I suspect that, in their heart of hearts, many city folk think we are living in a more binary world - that it will be bad deflation, or high inflation (maybe even one followed quickly by the other).

What seems strangely unlikely is a "just right" outcome in between. The Goldilocks economy really has gone for good.

That poses a challenge to policy makers and all of us. But spare a thought, too, for the fund managers charged with investing our fast-diminishing pension pots.

After all, if you think that deflation is the big danger, the traditional advice would be to pile into cash and bonds. If you think that inflation is enemy number one, then history would suggest that shares and gold are a safer bet.

But what do you do if you think that there's a roughly 50% chance of each?

It sounds like one of those peculiarly unhelpful weather forecasts. But that may well be the world we're in.

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