Deflation May Return to World Economy, Say SocGen, Deutsche

By Simon Kennedy

July 11 (Bloomberg) -- Societe Generale SA's Albert Edwards, who predicted the Asian currency crisis a decade ago, is warning central bankers that deflation may soon overtake surging prices as the biggest risk to the world economy.

``Inflation fears are overdone and the deflation threat could reappear, prompted by a global recession and collapse in the commodity bubble,'' London-based Edwards, 47, said in an interview. He has been ranked Europe's top global strategist for the last seven years by the Thomson Extel survey of investors.

While his forecast that prices in the U.S. and Europe will be falling by the end of 2009 is dismissed by most economists, it echoes last week's acknowledgement from the Bank for International Settlements that a ``greater'' global slowdown risks triggering deflation. As central banks from Mumbai to Frankfurt raise interest rates, policy makers could yet be forced into a U-turn, say economists at Deutsche Bank AG.

``Far-fetched as it may sound at present, fears of deflation could return and interest rates could drop again toward the lows reached earlier this decade,'' said economists Peter Hooper, Thomas Mayer and Torsten Slok in a July 7 report. While it's not part of their central forecast, a period of declining prices is more likely than runaway inflation, they say.

Just over four years ago, the Fed's benchmark interest rate was at a 45-year low of 1 percent as it fought the last deflation scare. Japan's escape from a decade of declining prices remains fragile with prices excluding those for food and energy dropping 0.1 percent in May.

Deflation Worry

``The fact that people are worrying about inflation now doesn't mean they won't be worrying about deflation in a year,'' said Edwards.

Most economists are still raising their forecasts for consumer prices as food and fuel costs set records. Larry Kantor, head of research at Barclays Capital in New York, estimates global inflation of 5 percent this year, the fastest pace since 1983.

Central bankers are ratcheting up their inflation-fighting rhetoric. European Central Bank President Jean-Claude Trichet said July 9 that he sees the ``first signs'' of inflation pushing up wages. Federal Reserve Bank of Richmond President Jeffrey Lacker said the previous day the central bank should consider acting to limit inflation as the threat of a steep economic downturn fades.

Long Way

The ECB already lifted its key rate last week to a seven-year high of 4.25 percent and the Fed left its main rate at 2 percent on June 25 amid ``upside risks to inflation.'' Merrill Lynch & Co. economists predict 78 percent of the central banks they monitor will increase rates.

``We're a long way from deflation,'' said Dario Perkins, an economist at ABN Amro Holding NV. ``We have to get through the inflation problem first.''

Edwards counters that such concerns are exaggerated because weaker global growth will prevent workers from winning pay increases and companies from raising prices. That will depress so- called core inflation, which strips out oil and food prices, he says.

``The market would then wonder why central bankers spent so long jumping at inflationary shadows,'' said Edwards, who in May recommended investors cut their exposure to stocks and boost holdings of government bonds. In the U.S., core prices rose 2.3 percent in May, less than the 4.2 percent headline advance.

Inflation Bout

The current bout of global inflation may itself contain the key to a spiral of falling prices, says Mark Cliffe, chief economist at ING Financial Markets in London.

A jump in the oil price to $200 per barrel could generate a global slump, sparking a plunge in the price of crude and ``outright deflation in the U.S.,'' he says. Oil cost $136 a barrel yesterday, down from a record $145.85 on July 3.

At the Basel, Switzerland-based BIS, the bank for central banks, the concern is the present ``global slowdown could be much greater and longer-lasting than would be required to keep inflation under control,'' it said June 30. ``Over time, this could potentially even lead to deflation. Such an outcome, even if unlikely, cannot be ruled out entirely.''

David Owen, chief economist at Dresdner Kleinwort in London, says deflation may be some way off yet, but may develop in three to five years if the world economy remains sluggish.

``Whatever is happening with inflation at the moment, the outlook for growth is pretty grim,'' said Owen. ``You can build a fairly convincing case that deflation will return to the agenda.''

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net.