Inflation - tame but under control?

Since the global recovery started in the string of 2009, inflation has been moving higher. The US recession ended in June of 2009, so the rate of inflation has doubled since that time. We are not at 2008 levels, but the major economies are showing signs of rising prices. The issue is whether inflation is under control. It is tame, and it is following the path expected by central bankers, so it is hard to say that anything is out of the ordinary. The fears are not with the next two of three quarters but what will happen over the long-run, if central bankers do not start the tightening process at the right time.

Oil price shocks and current accounts

The sensitivity chart shows that a oil price shock is not going to help everyone the same way. For oil producers, the current account surplus will increase. While those countries that have high oil imports will see deterioration of their terms of trade and a decline in their current account. Many of these countries are not in good financial shape, so the price increase will further enhance the economic difficulties of those with debt problems.

The success of QE2

The charts above are from St Louis Fed president Bullard. The quick take on the QE2 policy is that it is working as expected. One, TIPS break-even inflation rates have increased from their lows. Two, stock prices have increased from their lows. The monetary eases has had the desired effect on financial prices. Three, real rates have increased, consistent with higher economic growth. All is good!

However, there is a potential problem when we look at output gaps. The story hear suggests that there may be less slack in the global economies than expected. If this is the case, there may be more room to tell a inflation story that could be less controlled. We may be early in the process, but this is the fear for many investors.

Could higher commodity prices be deflationary?

With oil prices rising from geopolitical risks in the Middle East and with supply shocks in many commodity prices still upon us, we have to ask the question of whether the price gains are related to inflationary expectations or just supply imbalances.

The supply imbalance story especially for oil would suggest that the higher prices will negatively affect consumer balance sheets and production costs. In this case, economic growth would slow and the net effect would be for another recession. This could lead to lower core inflation rates or deflation.

The inflationary expectations story is that commodity prices will gain because excess cash is used to buy commodities as a store of value. At low interest rates, the cost of holding commodities is low. Clearly, index interest suggests that commodity demand is on the rise, but the pass-through to the economy is more uncertain.

The problem for central bankers is trying to separate what is going on with prices. This is not easy and makes the chance for overshooting greater.

Note the following views.

David Rosenberg:

It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock

Ambrose Evans-Pritchard:

The classic theory by Rotemberg and Woodford (1996) is that a 1pc rise in crude prices cuts 0.25pc off US output over six quarters or so. If they are anywhere near correct – and the “energy intensity” of the US economy has diminished over time – the sort of 40pc rise since last summer rise will indeed have a severe effect. Subsequent scholarship suggests this is too extreme, unless central banks behave like idiots.

The oil and natural gas dynamics

The New York Times produces a good graphic on the relative dynamics of oil and gas. They are both in the energy markets but they represent very different supply and demand dynamics. Oil is global market which has strengthened on the demand from developing countries while the natural gas market is more localized and will be effected by relative supply within a region.

Buiter on 3G growth - it will not be

Willem Buiter, chief economist of Citibank has constructed a "3G index" to measure economic progress; 3G stands for "Global Growth Generators" and is a weighted average of six growth drivers that the Citigroup economists consider important:

1. A measure of domestic saving/ investment
2. A measure of demographic prospects
3. A measure of health
4. A measure of education
5. A measure of the quality of institutions and policies
6. A measure of trade openness

Using that index the nations to watch over the coming years are Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, the Philippines, Sri Lanka and Vietnam.

It is interesting that there are no G10 countries in this list. Nothing from Eastern Europe. One oil country from Africa and no Latin American countries. The real issue is what policies are necessary to become a 3G country? Clearly all of the above countries are headed in the tight direction, but it is less clear how stable are those trajectories.

Dani Rodrik on the world political trilemma

You cannot have a fully globalized world economy without a significant amount of political integration and transnational cooperation.

“the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance.

The political trilemma can be used to explain the major problems within the EU. It can also explain some of the key international finance issues concerning China and the dollar. How much international governance should exist? It is hard to say, but we can agree that the concept of the nation-state will have to change. We cannot have it all and we have to recognize the limitations between forms of government and globalization.

Kohn on inflation

Former Vice Chairman Kohn at a UofC monetary policy conference:

A global increase in commodity prices is “an adverse thing for the economy,” Kohn said. “It makes the monetary policy process more difficult.”However, “if those inflation expectations can remain anchored, it doesn’t really require the kind of response that some people are calling for.”

The issue is the link between inflation expectations and commodity prices. The Fed views food and energy as exogenous shocks or relative value shocks. Hence, policy should not be swayed by increases in food prices. In reality, higher food prices may cause general price expectations to increase. Similarly, a price increase in energy may cause a drag on the economy which may force the Fed to monetize to spur growth. Again, inflationary expectations may increase.

“Inflation will move up to the FOMC [policy-setting Federal Open Market Committee] target of 2% or a little lower, but it will probably take several years to get there,” This comment suggests that the Fed does not believe that any of the price shocks will translate to higher inflation. This may be a dangerous assumption.

Yellen speach on monetary communication

Fed Vice Chairman Yellen provided interesting comments on monetary policy communication. Her argument is that the Fed could have a greater impact if it could provide better communication on its policy intent. In this case, if the Fed communicated that they would hold steady their current easing policy for a longer time period, the market would be able to form better expectations on the inflation and growth.

If the market expects the Fed to stay more accomodative, then the result will be more accomodative. The unemployment rate would decline and core inflation would go up but this would all be good.

The Fed funds rate is suggesting that rates will have a 1/3 chance of rising at the end of the year. The Fed has to make people believe that this will not happen to keep rates low. Of course, for longer rates there is the issue of whether the markets believe there will be higher inflation and have started to force nominal rates higher. What happens if the markets actually believe that the Fed will stay accommodative? The result may not be good.

QE2 will continue as long as inflation stays low

US core inflation rates are well below the 2% target even with recent increases. The PCE index of inflation, the Fed's choice, is below the 2% target. Headline inflation is also below the 2% target. Inflationary expectations are moving higher but still not in any danger zone. 10-year break even inflationary expectations are at 2.29 from a low of 1.5% at the end of August. Hence, the policy approach is going to be status quo.

The latest Fed comments are that core inflation expectations and reality will stay low. Do not worry, there will be no inflation. Yet, the result of the world is starting to think differently.

Inflation linked bonds have doubled but may not be best trade

Baring Asset Management –

If, as central bankers say, it is the exogenous factors, such as commodities and food, that are driving inflation higher, the ones that they cannot control, then it makes sense to get exposure to them.”

This is an interesting argument for commodity exposure but makes sense. If the commodity prices will always be independent of central ban action, it would seem that this is the area of most potential risk. Obviously, if the central bank wants to generate inflation, then inflation linked bonds would be a better option. However, governments actually control the measurement of inflation.

The supply of inflation linked bonds have increases substantially over the last five years with the size doubling in France, UK and the US, but the size of deficits have increased even more so the relative importance of inflation linked bonds may have diminished in many countries.

Governments may not want to stop the issuance because that will send a clear signal to the market that inflation is going higher, but they really do not want to index all of their debt to inflation rates which are headed higher. Certainly inflation rates are near their lows in many G10 countries and have trended higher.

Inflation linked bonds have not been a great deal for investors because real rates have moved into negative territory. Paying the government to hold your money when they also may control inflation is not something that seems to be a good trade.Currently 5 year TIPS in the US are trading at -.28 yields The 10-year TIP is positive at 1.13 percent.

So how can investors escape the inflation cycle? An investment in commodities may serve as a useful addition to portfolios.There will be a price gain from the movement in commodities with a cash return based on the investment in futures.

Feeling the heat: global Inflation

Great graphic on inflation from the Wall Street Journal. This graphic provides information on the inflation each month for every economy and color codes the inflation by its intensity. Included is the url for using the interactive tool. It sends a clear message on which countries are facing higher inflation.

UK Government Office of Science report – Malthusians are still alive

The global food and farming futures study came out last month and it is fairly pessimistic about the chance for cheap food around the world over the next few decades. It argues that an agricultural revolution is needed to feed the almost 9 billion people who will be on the planet in the next few years. There has to be "sustainable intensification" which will increase food production without hurting the environment.

There is no question that currently there is a major supply shock in many commodity markets but we have to realize that the real price of food has generally been declining for decades. Every time there is a sustained increase in prices does not mean that there will be a long-term shortfall in food.

These doomsday predictions are the traditional Malthusian approach to food analysis. We will run out of it if we are not too careful. Yet, it has not happened. Most of the famine in the world has been created by man-made events. The allocation process is the key to getting people feed not the long-term production. That being said, there has to be new innovation that will offset the fact that the cost of farming has increased and there is a shortage of land for farming. There will also be a shortfall in water. This means that food problems can only be solved if there is innovation to increase crop yields. Of course, innovation cannot be mandated through a simple policy.

Innovation is still one of the major mysteries of economics. R&D money will help and when prices increase the need and response of innovation will also increase, but it is not clear that ingenuity will arise spontaneously. Governments can help with research by allowing for the sharing of information on plant genetics. This is one area which cannot be lock-up through patent restrictions.

Looking at planting intentions and the clear backwardation of many commodity prices, there will be a increase in supply as a resposne to recent price gains. This will be a good first start to help in the short-run. In the long-run, governments can push policies that do not overuse commodities or restrict farm output.

Emerging market inflation and output gaps

While there has been talk about the emerging market inflation, all of the countries cannot be placed in the same bucket. The inflation rates across countries can be divided or conditioned on the output gap within the country. Those countries which have high output gaps generally do not have inflation worries while most countries which are facing high or increasing inflation rates do have strong output gaps. Countries which have some output gap and inflation worries are usually those with a commodity focus. Consistent with economic theory, those countries which have economic slack will have less price pressure.

The places to worry about inflation include the following:

Overheating economies - inflation and negative output gap -Argentina, China, South Korea, and Singapore

Inflation and no output gap - Brazil, India and Poland

Index of vulnerability to rising food prices high for emerging markets

Citigroup has develop a index of vulnerability to rising food prices which looks at the weight of food in the CPI index, a measure industrial capacity utilization and monetary looseness to measure the impact of food inflation on an economy. A high food component will mean that food will always be important to inflation. High capacity utilization means there is no output gap which means that higher food inflation can be translated into higher overall prices. Loose monetary policy always help to allow prices to move higher as buying increases from excess money.

China happens to top the list and provides ample reason for monetary tightening. Places like Russia and South Africa do not seem to have the same problems with food price increases.

McFlation index as a CPI check

The Economist had an interesting article concerning a new index from a UBS economist to check the inflation rates in the street versus official inflation numbers. Called the McFlation index, it looks at the price change of Big Macs around the world and compares against official inflation rates.

Now comparing one item against a basket is never a good way to check inflation statistics, but it does provide a nice universal measure of a good with multiple inputs. The data suggest that Argentina and Brazil inflation is much higher than measured by official numbers while Russia and Indonesia may have over-reported the inflation rate over the last ten years.

This is not a good measure to make any inflation bets, but it does focus on a simple good traded all around the world. Food costs have gone up in all countries so a general increase in meat would not bias the numbers. It is something to watch in the coming year to see if the Big Mac inflation index tells us more about relative inflation against official announcements.

G20 wants to be involved in food crisis

Watch-out, the G20 has noticed there is a food problem with higher prices so that means that they want to do something. With commodity prices reaching near highs of 2008, there is a growing concern that governments should act to allay the increase in prices. There has been a rise in hunger and political instability in many developing countries so the governments should do something instead of just letting market forces work.

French president Sarkozy is placing food security at the top of the G20 agenda; however, some of the blame of any food crisis should be associated with the current agricultural policies of the G20. In 2009 at the L’Aquila summit, the G20 promised $22 billion in financial support to third world countries including a special fund called Global Agriculture and Food Security Program. Only $350 mm has been received for this program. Just stop with the money promises that cannot be kept.

If you want to solve a shortfall in corn, stop subsidies for ethanol. Stop subsidies to inefficient production in the EU. Stop policies that stilt production in third world countries through developed market import restrictions. Allow for more genetic crop production, or at least let the science try and improve crop yields.

Regulation of agricultural markets cannot be a substitute for production. Allow markets to allocate funds through reduced interference in agricultural markets. It is not what policy-makers want to hear, but it is worth a try.

Emerging markets have lost luster

Emerging market stock indices have been on a decline since November. For some these markets have lost their luster, yet growth in the emerging markets should well top the growth in the developed markets. Does this make sense?

This is where the inflation story in emerging markets is useful. Many emerging market central banks have started to raise rates in an effort to stop inflation. For example, the India central bank has increased rates seven times since March in order to cool the economy. The impact on stock prices is being felt. Until it is viewed that central banks have some control over emerging market inflation, we will see weak equity markets. The weak inflation in G1o countries with continued easing monetary policy seems to be more attractive to global equity investors.

Savings demographics – a drag on equity markets

The Economist Buttonwood column has a nice story on savings and equity markets from research done by Barclays Capital. We know that savings will have a key impact on equity markets. You need more savings to provide flows to invest in order to get equity markets to go higher. What Barclays found and what is consistent with research on equity risk premia is that relative savings may be the key ingredient for driving equity markets.

In particular, the ratio of young and old investors relative to middle age will determine long cycles in equities. When there is a skew to younger or retiree age groups as a percent of the population there will be less savings. This would be the 25-34 age group and those over 65. As the population of the 34-54 age group increases, there will be an increase in savings and more money invested in the stock market.

The demographics run against the US stock market because the number of retires will be increasing. The young will also be increasing. Hence there will be demographic headwinds against the stock market. Note that this same demographic headwind will have an impact on the global savings glut. Many of the emerging markets have young populations which will be spending money and not savings.

Just be long stocks and do not worry?

Ben Bernanke's November speech led to a second round of equity gains. The first round came with announcement of QE2 in August. This equity rally will continue until there is a new vision on monetary policy.

From Bernanke:

“…Higher stock prices will boost consumer wealth and help increase confidence, which will also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion…”

Bernanke is following a Greenspan playbook of using financial markets to gain a wealth effect. The wealth effect has not been viewed as very strong but it seems to be one of the key tenants of current monetary policy.

The stocks markets should make most investors nervous. In spite of nice gains since August, investors should be unsettled by the increases in equity prices. First, valuations look like they are high as measured by the Robert Shiller cyclically-adjusted P/E ratios. Second, there is a disconnect between central bank behavior and the robust gains in equities. Low interest rates are necessary to help fragile economies, yet if economies are fragile we should not need low rates. Low rates which help equities may not be a positive sign for long-term gains; nevertheless, as long as the Fed signals that it wants to get financial asset prices higher you have to be part of the wave.

China currency – real versus nominal appreciation

Understanding the difference in real versus nominal exchange rate changes is a key concept in currency economics. It should be the case that real exchange rate appreciation will change the competitiveness of goods and will affect the balance of payments. An increase in the real rate should lead to a decline in the trade surplus. Nevertheless, empirical research by Chinn and Wei has found that there is little link between flexible exchange rates and changes in the current account.

For all of the talk about fixed or controlled rates in China, there has been a clear appreciation in real terms. The Economist provides a nice graphic which shows that on a real basis, the Yuan has seen significant gains. The problem is that has not resulted in declines in the current account.

In real terms, the US and rest of the world may actually like for China to have higher inflation. If higher inflation leads to higher nominal wages, some of the costs will be past in export prices. This will make Chinese goods more expensive which will change the terms of trade. The effect will be the same as an increase in the exchange rate. Notably this effect will also export inflation to the rest of the world.

There are no easy answers with the China imbalance but we are heading in the right direction.

G20 summit – no real progress

The G20 meeting provided some guidelines for tracking global imbalances but there was little coordination to solve the problem. See the complete text. The following provides the broad guidelines that were discussed. It includes everything possible for discussion on international finance.

While not targets, these indicative guidelines will be used to assess the following indicators: (i) public debt and fiscal deficits; and private savings rate and private debt (ii) and the external imbalance composed of the trade balance and net investment income flows and transfers, taking due consideration of exchange rate, fiscal, monetary and other policies.

As highlighted by a Goldman Sachs economist, “The number of potential indicators and measures references in these sentences reads like a concentrated summary of a textbook on international economics.”

Enough said.

Stress index says not to worry

The St Louis Fed Reserve financial stress index continues to fall and move to pre-2008 levels. NBER stated that the recession began in December 2007 and lasted until June 2009. We continue to show improvement with the momentum of the index moving in the right direction. Note that the index spiked during the Greece debt crisis but has moved lower with the increase in equities. The index is a composite of 18 variables, including 5 volatility measures, 7 interest rates and six interest rate spreads. See the St Louis Fed website for more details.

Gold silver ratio seems out of line?

Ever since the period of bi-metallism, traders have looked at the gold silver ratio as a measure of value. Silver has become known as "poor man's gold". So if the ratio get very high, the price of gold will be high relative silver and there should be an increase in silver demand. Unfortunately, the relationship has not been stable so it is hard to say what is the level of extremes.

From Investopedia, Here's a thumbnail overview of that history:

• 2007 – For the year, the gold-silver ratio averaged 51.
• 1991 – When silver hit its lows, the ratio peaked at 100.
• 1980 – At the time of the last great surge in gold and silver, the ratio stood at 17.
• End of 19^th Century – The nearly universal, fixed ratio of 15 came to a close with the end of the bi-metallism era.
• Roman Empire – The ratio was set at 12.
• 323 B.C. – The ratio stood at 12.5 upon the death of Alexander the Great.

Noteworthy is the fact that the ratio has declined significantly with gold somewhat rangebound and the price of silver moving higher. There are some key reasons for the current silver run.

There is strong backwardation in the silver market like copper. Gold is in contango. There is a supply shortage especially with China now being a net importer, and high short interest that some think will be squeezed in the current rally.

There is speculation that the SLV ETF does not have enough silver to affect a delivery to China. Last year China imported 3,500 tonnes of silver while it was an exporter of 3,000 tonnes just five years ago. Imports surged 400 percent in one year. The current story is that Asian investors have been buying the SLV ETF in order to take delivery of silver. If an investor acquires 50,000 shares, these can be presented to a broker dealer in the ETF for physical silver. A squeeze would occur if the silver was not readily available.

If the supply and demand story is to be believed then the gold silver ratio could fall even more in the next few weeks. There is no cheapness in the ratio.

Food and inflation - the weights make a difference

Inflation in emerging markets is outstripping the increases in the developed world. This must be caused by their strong growth. Not exactly. If you look at the weights for food in the CPI indices of many countries, you will see wide divergences Food is over two times as important in the Indian CPI than in the US. Consequently, if there is a shock to food prices, there will be a greater increase in inflation for some countries. Emerging markets will generally have higher food weights, so for the same food price shock there will be a greater increase in headline inflation.

This also means that the link between commodity prices and inflation will be stronger with emerging markets. Commodities will play a more important role as an inflation hedge in these countries.

Playing the intermediate dollar moves

The dollar is a strange animal because it has a special place as a safety asset. If risk-taking is off, there will be a flight to the dollar. If risk-taking is on, the dollar will decline. This safety behavior is associated with reserve status even if the current account and fiscal deficits are high.

Another way of viewing the dollar is through capital flows and not just risk-taking safety behavior. The capital flows argument suggests that the dollar is counter-cyclical. It will under-perform when there is global economic expansion. This under-performance of old world currencies is a result of it being a supplier of equity capital to the rest of the world in an expansion. In a contraction or when risk increases, there will be a pull-back of flows and a dollar appreciation. This capital flows argument applies especially to emerging markets. Hence , if there is further strong global growth, we expect to see USD to depreciate versus EM currencies. This should be more pronounced for commodity currencies. This relationship will not apply to G-10 currencies where rates and relative growth will be the main drivers.

CNY startng to increase - a trend?

The yuan has started to further appreciate. If you look at some simple moving averages, you will find the yuan below the 20 day as well as longer-term averages. It is currently at 6.575. The yuan has taken on a stair-step process with a decline followed by a rest and then a further decline. Monetary policy has tightened with continued increases in reserve rates and it look like the PBOC is willing to allow further appreciation to help control inflation. The PBOC sets a fixing rate everyday with a tolerance of .5 around the mid-point.

Of course, the PBOC has stated that any changes are not the result of external pressure for appreciation.

PBOC governor Zhou Xiaochuan reiterated that Beijing would decide the pace of yuan appreciation on its own and would not take into account pressure from other countries. "External pressure has never been an important factor of consideration and we have never paid special attention to it," Zhou said in Paris at a G20 gathering of monetary policy heads.

Some have noted that yuan appreciation usually occurs around political events like the G20 meetings, major elections or summits.

No inflation in developed countries - think again

Looking at latest European cost of living index will show rates up at 2.6%. This is from a low of .2% in July of 2009. Now this is not much versus a 2% target and it is much lower than the 4.4% in July of 2008, but there is a clear trend. The UK is up to 3.3%.

Interestingly, some of the countries with the slowest growth in the EU have the highest inflation rates. The World Bank is now saying that rising food prices has pushed 44 million into extreme poverty.

All of this pressure may force more central banks to raise rates. We are seeing this occur in emerging markets, but the true global monetary tightening will begin when the G3 start to raise rates.

Best quotes for the week

These are quotes taken from the financial philosopher. A good blog on deep thoughts about markets. The questions are always the same. Why is it so hard to change and break old habits?

Kent Thune, “If one wishes to be wise, however, one will acknowledge one’s own ignorance, observe the herd from a distance, and perhaps shrug in amusement.”

"Faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof." ~ John Kenneth Galbraith

'I have done that', says my memory. 'I cannot have done that', says my pride, and remains inexorable. Eventually--memory yields. ~ Friedrich Nietzsche

"Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes." ~ Jesse Livermore

"Not choice, but habit rules the unreflecting herd." ~ William Wordsworth