Inflation and Interest Rates
There is one long term global trend that already effects price levels and will continue to do so. The integration of China and India in the world economy by the admission to the World Trade Organization has added more than 2 billion workers to the global workforce. This is what economists call a positive supply side shock as the production potential has increased. This increased production potential will keep a lid on prices worldwide for years to come. This deflationary trend is the underlying trend for the next 10 to 20 years. The slightly higher inflation rates in Europe and the US in the last quarters are mainly due to higher oil and commodity prices. However, the core inflation rate has remained low and once the oil and commodity price start falling the consumer price indices will fall below the core inflation rate and therefore to around 1.0% in Europe and the US in late 2006 or 2007. There is no need to talk about Japan at this point, as their only problem is to get inflation at all.
Interest Rates
Based on the analysis of the economic background, the oil price development and the inflation scenario we expect the following development in interest rates. As the global GDP growth rate will be about the same in 2006 as in 2005 and the falling oil price will push the inflation rate lower we expect interest rates in general to stay low. Concerning the US Fed Funds rate we expect it to rise to 3.75% or 4.0% at the maximum during the next month, from now 3.5%. As noted above in the US inflation remains well contained, GDP growth will slow down slightly due to lower growth in consumer spending and the lower oil price will push the consumer price inflation below the core inflation rate, which stands at about 1.5%. Under this scenario the FED and the public will start to worry about deflation again during 2006. Therefore we expect 4.0% to be the maximum FED funds rate in this tightening cycle and expect the first rate cut to occur during 2006. One needs to remember that deflation is more dangerous than inflation, as inflation can always be fought with higher interest rates, but deflation can not be fought with lower interest rates, as rates can not drop below zero. There always remain the unconventional measures to fight deflation, but all of those carry their specific risks. An additional risk in the US are the high property prices, which would increase deflationary tendencies if they stop rising or start falling. We do not expect a housing market crash but we forecast lower price increases or a flat market over the next 2 or 3 years. The last thing the FED needs, would be a slower economy, the consumer inflation rate falling below 2.0% and a weaker housing market. To avoid this scenario we expect the FED to start lowering interest rates in 2006 at a rate that “is likely to be measured”. For the long term bond (10 years) we expect the interest rate to stay around 4.0% during 2006 and heading towards 3.5% in the second half of the year, as a cut in the Fed funds rate becomes imminent. This interest rate scenario should support the housing market, and continue to enable consumers to perform equity withdrawals, but on a much smaller scale than in prior years. In Europe the ECB, will either keep interest rates at 2.0%, or lower them to 1.75% until the end of 2006, as consumer price inflation falls below 2.0% and the economy remains weak. The German 10 year government bond, which acts as a benchmark bond for the Euro area should yield around 3.0% during 2006 and fall below 3.0% during the second half as consumer price inflation continues to fall, due to lower oil prices.
In Japan the central bank will keep interest rates near zero throughout 2006, even if deflation comes to an end as is expected by the central bank. The economy remains weak and there is no obvious area, which would grow strongly in the near future. The government plans to reduce the budget deficit in 2006 and 2007, which would have a negative impact on GDP growth over that time. We therefore expect the money market rate to remain close to zero as the central bank has stated to continue its monetary policy in that way until deflation is clearly defeated. 10 year government bonds should yield between 1.0% and 1.5% during 2006 under this scenario.