Photographer: Nir Leshem/Getty Images

An Inflation Warning From the Land of Negative Rates

“It feels like someone has killed inflation expectations.”

Risto Murto, the chief executive officer of Varma Mutual Pension Insurance Co., which oversees $46 billion in assets, says all the evidence now “definitely” suggests that the “disinflation risk is greater than the inflation risk.”

The Nordic region is the ground-zero of negative interest rates, but with no inflation to show for it. Since Denmark went below zero in mid-2012, inflation has slowed dramatically to just 0.3 percent in July. In Sweden, where policy rates went negative in February last year, headline consumer prices have grown less than the central bank’s 2 percent target since late 2011, and rose at only half that pace last month. Euro-zone prices crept up a mere 0.2 percent in July.

Even in the U.S., there are signs that the Federal Reserve is showing apathy toward the threat of inflation. Minutes of the latest meeting suggest that the Fed overall sees a “relatively low risk that a further gradual strengthening of the labor market would generate an unwanted increase in inflationary pressures.”

“Things feel totally different now from what we experienced in the 1980s and 1990s; nobody is really discounting an inflation problem,” Murto said in an interview in Helsinki.

Varma isn’t the only fund wondering what happened to inflation. In Denmark, the $115 billion ATP fund says it’s been pushing hedges against inflation further into the future.

“We’ve prepared for a world of lower returns and less central bank activity, but somehow the central banks keep coming back to the party,” Carsten Stendevad, CEO of ATP, said in an interview in Copenhagen.

“What we’re seeing today is an anomaly, but monetary policy is also abnormal,” Stendevad said. “Mervyn King’s work on inflation shows that throughout history, inflation came seven, eight, nine years after the end of monetary policy expansions. We’re not at the end, we’re still in it. We’ve survived and we keep pushing the insurance policies we have for that further out in time.”

ATP hedges against inflation in the form of swaps that reflect an assumption that a steep rise in inflation will also be associated with a sharp jump in interest rates. The fund keeps the contracts in place because a “sudden, significant rise in inflation” would be the “one particular scenario that would be extremely painful to pensioners,” Stendevad said.

That said, ATP is ready for a “substantial period of very, very low inflation,” he said. “A few years ago, the horizon was much shorter as we expected it would come much earlier. Now, we’ve pushed it out quite a bit on the curve and most insurances cover five to six, out through 15 years, though it goes all the way up to 20 years.”

Moderate inflation is considered healthy in an economy as it encourages consumers to buy now rather than later, when prices might be higher. That demand helps spur growth. In periods of deflation, consumers put off their purchases as they wait for prices to fall. The vicious cycle is associated with stalling demand. What’s more, inflation erodes debt while deflation adds to it.

A lot of funds have been relying on real estate investments as a natural inflation hedge. But Murto at Varma warns that assumptions on that being a safe bet are also risky in the current environment.

“Real estate gives you an inflation hedge, but you don’t get that at the moment,” he said. “So why is real estate doing so well? That must be because financing costs have collapsed. People are chasing yield. But the danger is that the inflation shock will actually be the other way around. And if there’s a deflation cycle, it’s actually real estate that will suffer.”

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