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Shift in inflation trend expected

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Continued low short-term interest rates and expansive US fiscal policys have helped get the global economy back on its feet. In the next phase of the economic cycle, long-term rates and inflation expectations will adjust to the new situation, according to the new UBS study entitled "Inflation." Although consumer price indices are not expected to spiral out of control, the markets' current inflation expectations are, if anything, too optimistic. UBS investment specialists are therefore advising investors not take up positions in long-dated bonds. Inflation-indexed bonds offer the best protection against inflation, and for that reason are to be preferred over investments in gold.

Booming economies in North America and Asia in particular have brushed aside the concerns over deflation that persisted until a year ago. But the financial markets have so far hardly come to terms with just how much inflation could rise and the consequences of such an increase for the various asset classes. The UBS study attempts to rectify this situation, positing a medium-term outlook for inflation going forward on the basis of a detailed analysis of historical data.

There have been very few periods of high inflation in the past. When such periods have occurred, they have often been caused by yawning budget deficits financed by printing money. Historical experience has shown, however, that market economies work best at moderate levels of inflation. As a result, most central banks have been granted a free rein in setting monetary policy to create just such an economic environment.

Recently, however, years of deflation in Japan have apparently made central banks more willing to tolerate a modest level of price rises. Cautioned by what happened in Japan, the US Federal Reserve in particular has shown a readiness to tolerate a degree of inflationary risk to prevent the economy from sliding backwards. High levels of debt among private households, corporations and governments also carry with them a particular risk of deflation. If the real debt load increases due to unexpectedly low inflation rates, this may lead to a shortfall in demand. The negative economic impact of such a development would likely be greater than the positive impact that would come from the potential real capital gains which could be achieved by creditors.

Overall, these considerations have led to a major expansion of the central bank monetary base, especially in the US and Japan, setting the stage for an increase in prices going forward. Globalization is no longer slowing this trend. The contribution of China and other emerging economies to world trade used to be mostly as suppliers of low-priced consumer goods. But these countries are now increasingly turning into buyers of raw materials and other industrial inputs, which has caused prices for these items to rise around the world. In addition, productivity growth in the United States is expected to slow. Wage increases will thus increasingly translate into higher prices for goods.

The overall outlook is therefore one of rising inflation. This increase will not, however, be uniform. With its sluggish economy, continental Europe will see low inflation rates persist for some time to come, while in the United States and some Asian countries prices are expected to rise at a faster rate. The level of inflation is not expected to be too high, however, as the independence that central banks have in setting policies is a key factor ensuring that it will not spiral out of control.

Although the financial markets are now working on the assumption that inflation will go up, a number of econometric models show that inflation rates could be much higher than the market is currently expecting. One result of higher inflation will be a downturn on the bond markets. History has shown that investment returns tend to compensate for inflation over the longer term. Stocks tend to perform better in a transition period from very low to moderate inflation, but seem to react badly to both excessively high and excessively low inflation rates. When it comes to loss risks, it is apparent that, in nominal terms, bonds are a safer form of investment than stocks, though over a longer-term investment horizon in particular, the real level of risk approaches that of equities. Gold has little chance of staging a comeback, even with higher inflation rates. Inflation-indexed bonds, which have become increasingly common, offer better protection. As a result, gold is losing its traditional role as a hedge against inflation risks.

In conclusion, it should be emphasized that over the last two decades most financial investments have benefited in both nominal and real terms from the decline in inflation and the corresponding reduction in the inflation premium. Without this support, returns on the financial markets will be much lower overall than over the past two decades.

Zurich / Basel, 26 April 2004