World of falling prices

Yesterday the gilt market recovered a little of its nerve, but it remains nervous, twitchy and fragile - as one might expect, given that it has endured a sharper shake-out in recent weeks than any other important bond market, with the possible exception of Italy.

One effect of the shake-out has been to force holders to question the wisdom of sticking with long- term gilts through the coming upward twist of the interest rate cycle. However, this is not just an issue for gilts, for unless something catastrophic occurs in the UK that does not occur in other developed countries, whatever happens to UK yields is going to happen elsewhere. The question that bond-holders worldwide have to ask is: how secure is the long- term downward trend in world inflation?

During the long-term secular rise in inflation through the 1960s and 1970s, bond markets tended to under-estimate just how bad inflation would be. In the early and middle 1980s, however, they tended to be over-pessimistic. And finally, in the past two or three years when the great bull run in fixed-interest securities really hit speed, they gradually recovered the optimism. Now, in the past couple of months, that optimism seems to have been shaken.

Intellectually, we are at a crossroads. There will be some rise in inflation in the US, and in all probability here too. But if this is just a blip, and inflation worldwide continues down so that by the end of the century it has to all intents and purposes disappeared, then there would be a positive case for buying bonds even at present levels. Yields in the present 6-7 per cent range would have seemed very high in the middle of the last century. Will inflation in the 21st century be akin to the 19th?

Forget about the small rise in the trend in UK earnings, the level of spare capacity in the US economy, or the dangers posed by monetary growth in Germany. All these issues will seem of minimal importance if we are about to have a century of falling prices. If the outlook were not just zero inflation, but minus inflation, than bonds would still be very cheap.

If this seems absurd, consider two points. First, were it not for sterling's devaluation since it left the ERM we would almost certainly have a negative year-on-year retail price index at the moment.

Second, prices in the UK in 1930 were roughly the same as in 1650. There were, of course, periods when prices rose - the Napoleonic wars, for example - but overall they were steady, for these quite sharp jumps were offset by long and gradual falls. On the very long view, it is the past 50 years that have been the oddity.

The chief objection that anyone drawing parallels with the past has to tackle is that during this long period of stable prices the anchor was gold. There is no completely satisfactory response to this. If one asks 'what does anchor prices now?' the usual reply is the feeble one that governments and central banks have become increasingly aware of the costs of inflation and will seek to curb it. But while that might support a set of conditions where inflation was in the 0-2 per cent range, it is hard to see goverments willingly seeking falling prices of about 1 per cent a year, as occurred during the last century.

To be confident that prices would be held steady, or even fall a bit, one has to have something stronger than governments and central bankers. There are two main candidates.

One, ironically, is the worldwide bond market. If, as has happened in recent weeks, the bond markets react in terror at any suggestion of a rise in inflation, that terror will force central banks to tighten policy. The discipline imposed by gold has, so the argument would run, been replaced by the discipline imposed by the international capital markets.

NEW PRODUCERS

The other is the move into the world economy of new, low-cost producers. Between 1950 and perhaps the mid-1980s only a tiny handful of new countries leapt across the barrier of development, moving from being poor primary producers to becoming rich, developed economies. Those that did were too small to exert much downward pressure on prices.

Now two-and-a-half new areas of economic potential have been added to the world economy: China, eastern and central Europe, and (the half, because it is much smaller) Mexico. These will hold down the price of all internationally traded goods, having an impact that a Hong Kong or a Singapore could not. Thanks to these new entrants, it is perfectly plausible that the Group of Seven countries could not generate inflation in internationally traded goods, even if they wanted to.

Plausible, yes, but is it correct? No one can know. From the point of view of the international investor, though, the return to world inflation in the 3 to 5 per cent range lies at one end of the risk spectrum. For most people, the other end would be zero inflation. The point above is that if that argument is at all plausible, then the other end of the spectrum is not zero inflation, but negative inflation - a world of falling prices.