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Prepare yourself for the return of

The world's leaders in economic disappointment are determined to have inflation. They will get it, and so will your portfolio, says Dr Peter Warburton
Financial markets have a small brain, capable of holding only a single thought at a time. Todays markets are oscillating between the following two thoughts: A: ination is the inevitable consequence of reckless monetary policy. B: ination is impossible while there is so much spare capacity. When markets fear ination (thought A), commodity prices rise, commodity stocks outperform, and commodity currencies strengthen. Moments later, when fear of deation (thought B) displaces fear of ination, commodity prices slump, commodity stocks dive and commodity currencies weaken. So for investors, the vexing question is whether to buy assets that protect against rising global ination, or those that prosper under deation. Some would argue that you should look at ination break-even rates. These rates compare the yield on conventional (xed-income) government bonds with those on ination-protected bonds, and are supposed to represent the markets' 'ination expectations'. However, they are better understood as the price of ination protection, or insurance. If you insure your car or your house, then you require the insurance everyday. After all, you dont know when any given disaster might strike. Investors, however, tend not to think about ination insurance this way. When they believe ination risks are receding, they cancel the policy and save the premium, expecting that the 10 same rates or better will be 9 available to them when markets 8 return to fretting about ination again. In truth, the price of 7 insuring against ination is a 6 lot more volatile than peoples 5 expectations for ination, especially on longer time scales. 4
Annual % change

epitomised by most nancial reporting. Examples of such short logic chains include the following ideas: rising interest rates lead to a weaker economy; an increase in government spending leads to a rise in GDP; or falling commodity prices lead to deation. Short logic chains sound perfectly reasonable. Yet they misrepresent the workings of a complex, dynamic system. The most insidious short logic chain of all is the idea that 'stronger economic activity means higher ination' and its corollary, 'weaker economic activity means lower ination'. Sometimes these statements apply, and sometimes they just dont. Welcome to Duckonomics.

Where does inflation come from?

We need a comprehensive framework to grasp the outlook for global ination. In a world of global supply chains and networks, this analysis makes sense only at the global level. So we have to consider all the potential ways that ination gets into the system. Broadly speaking, there are four main pathways for ination. 1. Keynesian overheating: think of the economy as one huge factory. Is demand for its output higher or lower than factory capacity? If lower, then resources are unemployed. If higher, then there is upward pressure on factory prices, and on the wages of its workforce. 2. Monetarism: households, rms and nancial institutions have a predictable requirement for money (combining purchasing power and store of value). But the monetary authorities may supply more money than is needed. Once injected, this extra money must be absorbed, which occurs through a general rise in prices.

Financial markets are capable of holding only a single thought at a time

Take America. If growth and ination were perfectly aligned, then all the data points on the scatter chart on the righthand page (which plots US growth and US ination against each other) would lie on a straight line, rising from bottom left to top right. In other words, growth would rise with ination and vice versa. Plainly, as you can see from the chart, they do not. Instead, they trace the outline of a duck. Strengthening economic activity is sometimes associated with falling ination. Weak growth and high ination can co-exist and have often done so.

3. Supply-side ination: advanced economies have outsourced the production of goods and services to lowercost producers in other nations. That leaves them vulnerable to ination that arises in producer countries, then passes along the supply chain to consuming nations. Take the quantitative-easingfuelled surge in global food and energy prices in 2010-2011, which triggered high ination in many emerging nations. The local price rise led to higher wages, and in turn, higher producer costs. As an aside, when we calculate Population-weighted CPI inflation global consumer price ination using population size, rather World (excluding China) World (including China) than economic size, as weights, World (GDP weighted) the ination trend looks a little different (as the chart on the left shows). 4. Fiscal ination: this is when government budget decits are nanced by central-bank moneyprinting. Until the nancial crisis erupted, government-generated ination was tame. Since then, it has roared back to life as central banks have absorbed roughly a

Simple ideas misrepresent dynamic systems

A variant of the markets single-thought syndrome is the short logic chain syndrome,

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MONEYWEEK 5 July 2013

US real GDP growth and inflation
4 3.5
Q1 2007 Q1 2006 Q1 2005

f inflation
third of all new government bonds issued since the end of 2007. This last route still has a very low prole, because bank lending to the private sector remains very weak in advanced economies. In effect, governments are generating replacement monetary growth and stopping the rate of global ination from falling even lower. But inationary danger looms if governments fail to shut down monetary nancing of their decits after private demand for credit revives. Once the central bank becomes the governments nancier, ination expectations become well and truly unanchored. That would be bad news indeed for government-bond prices.
GDP deflator (% pa)

3 2.5 2
Q1 2009 Q1 2008 Q1 2011 Q1 2012

Q1 2004

Q1 2013

1 0.5 0 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5
Real GDP growth (% pa)

Q1 2010

How does QE alter this picture?

So where do near-zero short-term interest rates and gazillions of quantitative easing t in to this framework? Have the policies pursued over the past ve years carried the global economy any closer either to sustainable economic recovery or runaway ination (or both)? The answer, unfortunately, is doubtful on the economic growth front, but afrmative on the ination side. Hopes that zero rates and QE would create a wealth cascade are foundering on both sides of the Atlantic. Japan might have to wait a little longer to reach the same conclusion. By contrast, there are many indications that QE has lifted the medium-term ination expectations of the public, undermining the solemn promises of the central banks. And worse is to come. Whereas conventional monetary easing (cutting short-term interest rates) permeates the nancial system, large scale purchases of government bonds or mortgage assets clearly favour specic priveleged groups. Capital market borrowers enjoy cheap rates, while small and medium-sized businesses remain dependent on banks and nance companies. The failure of QE to improve the common lot is its greatest indictment. Prepare for a backlash of popular disgust with far-reaching political consequences for the developed world.

economic, social, demographic and political realities. Developed economies have huge debt burdens, for which there is no monetary resolution as yet. Equally elusive is a political resolution: how much longer can we run budget decits at 5% of national income to allay voter anger? How can we keep a lid on geopolitical tensions that have their roots in access to affordable food, drinking water and energy? In our indebtedness, how will we nance the replacement and refurbishment of decrepit infrastructure before systems fail and there are supply crises?

The battleground for the global ination debate is the global wage bill
Most poignantly, how will the conicting interests of the generations be resolved? Older people want ination to be held down to preserve the real value of their assets and pensions. Younger people want house prices to fall and to reduce personal debt burdens through rapid wage growth. In Britain, 76% of over-65s voted at the 2010 general election; 55% of those aged 25-34 and 44% of adults under 25. Imagine how the adoption of internetbased voting options might alter those proportions and how that might turn into a winning electoral platform in the future. The battleground for the global inationdeation debate is not gold, nor copper,

nor iron ore, nor even oil. The true battleground is the global wage bill. The wages of youthful emerging nations are already rising, heralding mass prosperity in Asia and Latin America. In the mature economies of North America, western Europe and Japan, a more complicated conversation is taking place between cash-rich corporations, embattled households and indebted governments. Fed chairman Ben Bernanke may have inadvertently killed off QE on 19 June. However, the successor policies may well include overt monetary nance: government spending funded by centralbank money creation, with an emphasis on lowering the unemployment rate of young adults. Japan leads the developed world in economic disappointment and policy desperation. If Japan can confound its critics and steer a course towards 2% ination, then the rest of the rich-world countries will not be far behind. The Japanese voters handed a politician, whose previous short tenure as prime minister ended in failure, a resounding mandate to reate the economy. If Shinzo Abe succeeds in casting off the shroud of deation in Japan, his will be a psychological and a political victory more than a technocratic one. The global stage is set for the return of ination. Is your portfolio positioned accordingly? Dr Peter Warburton is director of Economic Perspectives Ltd.
5 July 2013 MONEYWEEK

Prepare for a political backlash

The case for the return of global ination is ultimately premised upon nancial,