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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. Today’s markets are oscillating between the following two thoughts: A: inﬂation is the inevitable consequence of reckless monetary policy. B: inﬂation is impossible while there is so much spare capacity. When markets fear inﬂation (thought A), commodity prices rise, commodity stocks outperform, and commodity currencies strengthen. Moments later, when fear of deﬂation (thought B) displaces fear of inﬂation, 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 inﬂation, or those that prosper under deﬂation. Some would argue that you should look at inﬂation ‘break-even’ rates. These rates compare the yield on conventional (ﬁxed-income) government bonds with those on inﬂation-protected bonds, and are supposed to represent the markets' 'inﬂation expectations'. However, they are better understood as the price of inﬂation protection, or insurance. If you insure your car or your house, then you require the insurance everyday. After all, you don’t know when any given disaster might strike. Investors, however, tend not to think about inﬂation insurance this way. When they believe inﬂation 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 inﬂation again. In truth, the price of 7 insuring against inﬂation is a 6 lot more volatile than people’s 5 expectations for inﬂation, especially on longer time scales. 4
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epitomised by most ﬁnancial 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 deﬂation. 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 inﬂation' and its corollary, 'weaker economic activity means lower inﬂation'. Sometimes these statements apply, and sometimes they just don’t. Welcome to ‘Duckonomics’.
Where does inflation come from?
We need a comprehensive framework to grasp the outlook for global inﬂation. 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 inﬂation gets into the system. Broadly speaking, there are four main pathways for inﬂation. 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, ﬁrms and ﬁnancial 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 inﬂation were perfectly aligned, then all the data points on the scatter chart on the righthand page (which plots US growth and US inﬂation against each other) would lie on a straight line, rising from bottom left to top right. In other words, growth would rise with inﬂation 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 inﬂation. Weak growth and high inﬂation can co-exist and have often done so.
3. Supply-side inﬂation: advanced economies have outsourced the production of goods and services to lowercost producers in other nations. That leaves them vulnerable to inﬂation 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 inﬂation 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 inﬂation using population size, rather World (excluding China) World (including China) than economic size, as weights, World (GDP weighted) the inﬂation trend looks a little different (as the chart on the left shows). 4. Fiscal inﬂation: this is when government budget deﬁcits are ﬁnanced by central-bank moneyprinting. Until the ﬁnancial crisis erupted, government-generated inﬂation 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
there are many indications that QE has lifted the medium-term inﬂation expectations of the public.com . then the rest of the rich-world countries will not be far behind. nor copper. nor even oil. inﬂation expectations become well and truly unanchored.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 ﬁt in to this framework? Have the policies pursued over the past ﬁve years carried the global economy any closer either to sustainable economic recovery or runaway inﬂation (or both)? The answer. governments are generating replacement monetary growth and stopping the rate of global inﬂation from falling even lower. is doubtful on the economic growth front. This last route still has a very low proﬁle.5 Q1 2007 Q1 2006 Q1 2005 f inflation third of all new government bonds issued since the end of 2007.opinion US real GDP growth and inflation 4 3. Japan leads the developed world in economic disappointment and policy desperation. Capital market borrowers enjoy cheap rates. 76% of over-65s voted at the 2010 general election. a resounding mandate to reﬂate the economy. western Europe and Japan. undermining the solemn promises of the central banks. The failure of QE to improve the common lot is its greatest indictment. with an emphasis on lowering the unemployment rate of young adults. Is your portfolio positioned accordingly? Dr Peter Warburton is director of Economic Perspectives Ltd. That would be bad news indeed for government-bond prices. how will we ﬁnance the replacement and refurbishment of decrepit infrastructure before systems fail and there are supply crises? “The battleground for the global inﬂation debate is the global wage bill” Most poignantly.5 2 Q1 2009 Q1 2008 Q1 2011 Q1 2012 Q1 2004 1. whose previous short tenure as prime minister ended in failure. the successor policies may well include overt monetary ﬁnance: government spending funded by centralbank money creation. However. www. Once the central bank becomes the government’s ﬁnancier. The Japanese voters handed a politician. while small and medium-sized businesses remain dependent on banks and ﬁnance companies. but afﬁrmative on the inﬂation side. Developed economies have huge debt burdens. In the mature economies of North America. how will the conﬂicting interests of the generations be resolved? Older people want inﬂation to be held down to preserve the real value of their assets and pensions. In Britain. GDP deflator (% pa) 3 2. heralding mass prosperity in Asia and Latin America. The wages of youthful emerging nations are already rising. 55% of those aged 25-34 and 44% of adults under 25. for which there is no monetary resolution as yet. Prepare for a backlash of popular disgust with far-reaching political consequences for the developed world.5 Q1 2013 1 0.moneyweek. 5 July 2013 MONEYWEEK 23 Prepare for a political backlash The case for the return of global inﬂation is ultimately premised upon ﬁnancial. The true battleground is the global wage bill. By contrast. Hopes that zero rates and QE would create a wealth cascade are foundering on both sides of the Atlantic. 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. because bank lending to the private sector remains very weak in advanced economies. drinking water and energy? In our indebtedness. demographic and political realities. large scale purchases of government bonds or mortgage assets clearly favour speciﬁc priveleged groups. And worse is to come. Japan might have to wait a little longer to reach the same conclusion. unfortunately. In effect. economic. his will be a psychological and a political victory more than a technocratic one. The global stage is set for the return of inﬂation. embattled households and indebted governments. Younger people want house prices to fall and to reduce personal debt burdens through rapid wage growth. If Japan can confound its critics and steer a course towards 2% inﬂation. Equally elusive is a political resolution: how much longer can we run budget deﬁcits 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. The battleground for the global inﬂationdeﬂation debate is not gold. Whereas conventional monetary easing (cutting short-term interest rates) permeates the ﬁnancial system. Fed chairman Ben Bernanke may have inadvertently killed off QE on 19 June. a more complicated conversation is taking place between cash-rich corporations. nor iron ore. social. But inﬂationary danger looms if governments fail to shut down monetary ﬁnancing of their deﬁcits after private demand for credit revives. If Shinzo Abe succeeds in casting off the shroud of deﬂation in Japan.
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