Vanguard experts discuss the inflation picture in Europe, the United States, and Asia.


Lara de la Iglesia: Roger, please tell us, what does the inflation picture look like around the globe right now?

Roger Aliaga-Díaz: Clearly, the same secular forces that are keeping inflation low and subdued in the U.S.—namely technology, globalization, the outlook for energy markets and for oil prices—are also creating a little bit of a drag, of secular forces keeping inflation low around the world.

Having said that, there are specific local market forces that create different inflation pictures or inflation environments in each market. For example, in the U.K., inflation is actually running above target, as opposed to below, like in the U.S. And the reason for that is the movements in the pound after the Brexit vote.

In Japan, on the other extreme, Japan continues to basically fight deflationary forces. Core inflation is at 0% right now, so the Bank of Japan is set to continue in its two-decade-long fight for creating inflationary pressures. And in Europe and the euro zone, particularly, the scenario is in the middle, in between the two other cases in which inflation is stable, core inflation is about 1%, more or less. Clearly, below the European Central Bank target for inflation, which is 2%. But at least a more stable inflationary environment, at least much better than two, three years ago.

Gemma Wright-Casparius: I think one of the important things, also, is China. So China last year really was in deflation. They’ve since moved back into small, positive inflation. And to the extent that we’re getting synchronized global growth and sort of uplift globally to inflation, I would say that the backdrop is more positive than it was just a year ago. And as long as global growth continues to synchronize to the upside into 2018, I would expect at least cyclical forces to keep inflation steady to a little bit higher.

Lara de la Iglesia: So let me ask a question, then, about the U.S. Is one of the reasons that U.S. inflation has been below historical levels, is that because the rest of the world has been slower to recover from the last recession?

Roger Aliaga-Díaz: Yeah, that’s a good way to think about that. There are clearly spillovers and connections globally in terms of inflationary forces. The way that inflationary trends transmit from one country to another is through the currencies. And that’s where the global picture matters.

The U.S. has been ahead of all the other markets in terms of their recovery, in terms of growth; not significantly, but slightly so. And that growth advantage, if you will, relative to Europe, relative to Japan, has translated into a strong dollar over the last two, three years. Even today the dollar is still 20% higher than three years ago, which is significant.

A stronger dollar means that the import prices, the prices of the goods and services we import from the rest of the world, are cheaper in dollar terms, and that tends to exert downward pressure on domestic prices. So the growth advantage of the U.S. relative to the others—a stronger dollar, cheaper imports. Imports represent about 18%, 20% of the consumption “basket” in the U.S. So, obviously, as import prices decrease, a significant portion of the family budget benefits from that. But, at the same time, that explains why inflation has been below what the Fed expected for the last two, three years. It’s one of the factors.

Gemma Wright-Casparius: And then we think going forward, as global slack disappears, you can see inflation basically continue to rise. We’re seeing labor markets tighten around the world. Growth is never synchronized. Monetary policy is never synchronized—fiscal policy.

So to the extent that we are seeing more synchronized growth and the central banks are not synchronized, so you still have Bank of Japan, Europe, very accommodative and still doing QE [quantitative easing]. You still see China and the U.S. slowly tapping the breaks toward higher interest rates to slow the economies from overheating. You’ve sort of got a one-two step, but global growth continues to move, the slack will slowly disappear, and over time—and it could be a multiyear process—but that will be an underpinning to core trends in inflation.

Lara de la Iglesia: So let me ask you a question then, Gemma. What should investors be considering in terms of their portfolio as they’re looking at monetary policy and inflation in markets like Japan and Europe or elsewhere?

Gemma Wright-Casparius: I think investors continue to monitor the global backdrop. I think one of the key indicators that we’re looking for in managing the funds is, When is there a synchronization in monetary policy? So when are the Fed, the ECB [European Central Bank], the Bank of Japan, and China all tightening at the same time? That would be a key indicator that perhaps there really is no more slack in the economy.

We think that’s many years in the offing. We don’t expect it right now. We still expect a slow, steady, gradual interest rate hike path out of the Federal Reserve, the balance sheet to come down slowly and gradually. But investors should consider that.

We haven’t mentioned fiscal policy at all so, certainly, [we] should. We’ve got some type of fiscal impulse in 2018. Be cognizant that with growth maybe a little bit faster, the Federal Reserve may hike rates a little bit faster and the market will discount that, obviously. But as always, we tell investors, “Set your objectives, set your investments, rebalance quarterly, and try to block out all the noise as you go along, and keep your objective in mind.”

Roger Aliaga-Díaz: Right. And I would like to add the global diversification, too, because this pull and push between, perhaps, a developed world that has been lying behind the U.S. but now maybe going forward is going to start catching up, will translate into dollar movements that perhaps will be more conducive to better returns for non-U.S. investments.

So the past two, three years have been a little bit challenging for your global bonds or global equities because the dollar has been moving against. You could think that as the rest of the world catches up with the U.S., as central banks in Europe and Japan start synchronizing with the Fed, you could see the dollar basically almost normalizing.

It’s not a prediction. Currency forecasts are very difficult, but this is why a well-diversified global portfolio makes sense, because you can basically benefit from these tailwinds in the currency that may be coming from the economy.

Lara de la Iglesia: Sure. So do you have any concerns that might be on the horizon, though? Is there anything that you’re monitoring in case there’s some unexpected changes?

Roger Aliaga-Díaz: Well, of course, the geopolitical events are always a shorter-term concern. Policy uncertainty at home is also another aspect. Those are events in which you may see a reversal of this risk on, basically, the environment we’re discussing with Gemma. We are being very hopeful about the future, but clearly that may be punctuated by events that basically create risk-off scenarios in which the dollar pulls back and your portfolios in international locations may not benefit that much. But, again, that’s why diversification is important.

Gemma Wright-Casparius: Yeah. The markets are also focused on central bank changes. So in 2018, [Federal Reserve] Chair [Janet] Yellen’s term is set to expire. In June of ’18 Vice Chair [Stanley] Fischer’s term is set to expire, and there’s already three existing vacant seats. One individual’s already been appointed and is going through the nomination process for the ability to reshape the Board of Governors. So key members in Washington who will help shape monetary policy in the U.S. is important to watch how that unfolds.

In Japan, there may be an election to replace Prime Minister [Shinzō] Abe. Governor [Haruhiko] Kuroda, who’s Yellen’s counterpart in the Bank of Japan, is also set to retire. And in 2019, Mr. [Mario] Draghi [president of the European Central Bank] is set to retire. So just the ability of changing of the guard of the leadership of the major central banks of the world will be something to watch. And in and of itself whether that changes the steady state and perception of the path of monetary policy going forward is something that we’re very watchful and mindful of as well.

Lara de la Iglesia: Great, thank you. Important to remember, though, we need to be informed but stick to the plan as investors.

Gemma Wright-Casparius: Absolutely.

Important Information:

All investing is subject to risk, including the possible loss of money you invest. Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

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