By Claus Vistesen
As the debate between the inflationistas and deflationistas appears about to rev up again, I thought that I would try to put pen to virtual paper and sketch out my thoughts on the matter.
The specific catalyst for looking into this is, naturally, in part the fact that oil looks set to do a round of catch-up with the rest of the frothy commodity space, but also this piece by the Pragmatic Capitalist citing David Rosenberg on the coming deflationary shock:
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
"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."
I think Rosey has this one spot on. The risk of rising oil is not a hyper inflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today's Case Shiller housing report for instance).
Hang on for minute then. Do you mean to tell me that we have been running around worrying about QE2 leading to bubbles all over the place while the real danger is continuing and entrenched deflation? Well, yes this exactly what this means, but note the important distinction between the US (and the OECD) and emerging markets. Greed and Fear kicks off this week with the following point [1];
(…) an oil-led commodity spike would clearly cause an intensification of the current inflation scare which has been hitting Asia of late with India the most vulnerable market. Still, as occurred in 2008, such a spike is likely to have the perverse effect of short circuiting the inflation scare in terms of duration. This is because sharply higher oil and food prices will hit current growing optimism on the US recovery. For ordinary Americans are not seeing the income growth to offset such prices increases.
This point is echoed in BCA’s chief economist Martin Barnes’ recent report, which exactly sets out to clear up the (non)-threat of inflation in the global economy.
Despite investor angst, the above analysis paints a relatively benign inflation picture for the developed countries. The policy mix of large fiscal deficits and highly stimulative monetary policies certainly appears inflationary. However, there currently is no excess monetary growth, and the pass-through from higher commodity prices is weak given ongoing slack in the economy.
(…)
The emerging economies are in a very different position [from the OECD]. All three approaches to inflation are telling the same story: There is excess money growth and the absence of slack implies that higher commodity and energy costs will push up wages and the overall prices of goods and services. Thus far, inflation is edging higher, not spiraling out of control. Nevertheless, policymakers need to get ahead of the curve by raising rates and, where necessary, allowing exchange rates to appreciate.
A large part of Barnes’ analysis is based on the notion of slack and, thus, the most illusive of all macroeconomic concepts, the output gap. But the argument is really quite simple. For cost-push inflation to lead to higher overall inflation there must be an built-in tightness in the economy for this to happen. This is to say that workers must be able to pass on rising prices to larger than expected increases in wages and firms must observe strong final demand in order to be able to pass on the increase in prices to consumers. Barnes’ argument in a nutshell is then that while capacity constraints might be an issue in the emerging world it isn’t in the OECD, still mired in a balance sheet/deleveraging recession.
This argument is interesting in relation to the notion of unintended consequences from low interest rates in the developed world and in relation to just what output gap central bankers should be looking at then. Enter James Bullard, president for the St Louis Fed and the discussion of the global output gap vis a vis the US output gap (hat tip FT Alphaville).
This argument combines the two points made by Barnes in the sense that, while the analysis of the US economy might certainly merit low interest rates for a long time given the excess slack of the economy, Bullard explicitly mentions the potential of adverse effects from ZIRP at the Fed due to an increasingly neutral to positive global output gap. Here is the FT’s John Kemp with the gist of Bullard’s speech as he sees it:
It is the first time a senior official at the U.S. central bank has acknowledged global capacity issues rather than a narrow focus on U.S. unemployment and capacity utilisation might give a better indication of where inflation is headed.
The obvious question here is whether the US should care at all about global capacity issues, but given my endorsement of Rosenberg’s point noted above, I obviously think they should. A central bank can argue up to a point that rising headline inflation should not be a reason for assuming a rise in underlying inflation pressures, but it is evidently obvious that as if an oil price rising to 120-150 USD (even for a short while) becomes a trigger for an even stronger deflationary shock, then the original argument for low interest rates becomes very difficult to make.
And finally, just to make sure we get all sides of the argument we should never forget that stagflation is also looming as an increasingly likely outcome in parts of the global economy (hat tip: Global Macro Monitor).
(quote from the Economist)
Historically, the margins of retailers and manufacturers have been remarkably stable, says Carsten Stendevad of Citigroup's corporate-advisory arm. If commodity prices continue to rise, they will eventually be passed on to consumers one way or another. After years of goods getting cheaper, consumers may have to start getting used to everyday higher prices.
This highlights a crucially important issue, namely the underlying trend of inflation in the global economy. It stands to reason that if the trend of global headline inflation is up due to structural capacity issues, an increased prevalence of adverse supply shocks and low interest rates, then bouts of headline price volatility may incrementally find its way into core prices. And in a deleveraging world facing the effects of a balance sheet recession, this is tantamount to stagflation.
What is the take then?
If the small tour above of the informed punditry serves to set the stage for the general argument, what are the important points to take away then?
Below I offer my suggestions.
Which door should you pick then to get it right on the global economy? You would not be surprised if my answer here is ambiguous. At the moment, I am leaning towards a 2008 re-run but precisely because it appears to be a re-run, it raises some additional important questions. Consider then the following from one of my friends;
The underlying problem is that the Emerging Markets as a group (while many of them are long term growth positives) simply cannot withstand the short term massive funding injection without food prices getting out of control. Food prices getting out of control produces, as we are seeing, political instability, and this leads investors to withdraw.
As noted above, this is then a issue of short term capacity to add as magnets of yield as well as long term capacity to rebalance the global economy. But this is the trend then, the speed and volatility matters too as another of my friends pointed out;
I think rates of change in oil price matter a lot more than the level. People adapt, but they can’t adapt quickly. We need to watch the speed of the oil price move. If it moves quickly, that could be a huge drag on growth like 1980, 1991, 2008.
I think these two arguments combined are very, very important. I would hold lingering deflation to be a near certainty in the European periphery and Japan where it never left. I also see many of the worst affected economies in Eastern Europe suffering a deflationary outcome. In the US, we will see and in the UK stagflation is a real threat if only because inflation may soon feed into expectations on a sustained basis. For the emerging economies as a whole, they will be fighting inflation for a long time to come, especially as the hunt for yield continues. In the end then, picking the door may depend as much of your time frame and unit of analysis as anything else.
—
[1] – I get G&F and a few selected of BCA’s publications through a well connected network of analysts and economists, but I cannot (obviously) reprint the whole editions here for copyright reasons.
Countries don’t go broke.— Walter Wriston, CEO of Citigroup, early 1980s
Does Quantitative Easing Work in Boosting the Real Economy?
View Results
Disclaimer: All data and information provided on this site is for informational purposes only. Creditwritedowns.com is not a financial advisor, and does not recommend the purchase of any stock or advise on the suitability of any trade or investment. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author(s). The author(s) may or may not have a position in any security referenced herein. Any action that you take as a result of information or analysis on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.
Read Full Article »