Monday, 9 November 2009

The deflation vs. inflation debate continues...

On Thursday I went to a presentation by Charles Dumas of Lombard Street Research and Ian Harnett of Absolute Strategy Research. Here are the key messages…

Charles Dumas in the deflation corner 

US fails all 4 of the Friedman's 4 steps to inflation (his evidence is in brackets):
    1. Rapid growth of broad money (money supply collapsed)
    2. Asset price boom (markets 25% off peaks)
    3. Overheating of economy (US in recession)
    4. Inflation (CPI falling)
    US M3 growth c. 4% but underlying this, the picture is different. Bank lending to private sector -6% so M3 growth coming from QE and govt stimulus 

    US unemployment rising (currently 9% which is highest since 1982), therefore wage growth negative. Dumas expects unemployment to continue rising & then stabilise as GDP next year will be way below normal recovery rates. Given the NAIRU (non accelerating inflation rate of unemployment) is 5-6% in the US, don't expect any wage growth (and by extension inflation) any time soon. Indeed, hourly wage growth of only 0.5% + rising unemployment rising CPI  

    US trend growth is c. 3%. Going forward, trend growth will be lower at 2.2% due to the collapse of key industries such as financials. In this recession, GDP has fallen -5.6% so output gap is c. -7.8%. If the US economy grew by +4% to +5% p.a. for 3 years the output gap would be closed. He therefore believes CPI will stop falling in 3 years time, although this is optimistic given lower expected growth rates. Dumas notes that the coefficient between the US output gap and CPI is c. 25% (i.e. if gap is -4%, CPI = -1%). 

    Finally, CNY/ USD peg has reduced Chinese export prices, which has increased China's market share. So, China wins if USD is weak, as does the US since their exports are also cheaper. However, this is negative for Japanese and European exports. 

    Conclusion slide shown below…

        Ian Harnett in the inflation corner 

        Inflation will be caused by 2 factors:
          1. Low inventories will result in frictional inflation due to supply shortages
          2. Liquidity creation is causing asset price inflation 
          This is more of a corporate rather than a consumer recession (e.g. US consumption contribution to GDP is still positive while investment & inventories are negative contributors). This is causing a supply shock. Supply chains have been built on the Great Moderation and are therefore unable to cope with economic volatility and associated sudden pick ups in demand. To demonstrate this he looks at US ISM prices paid and ISM inventories minus shipments (orders), which move in tandem (see chart). Both are positive as prices paid are rising due to sudden inventory rebuild.

            The corporate response to the credit crunch has been to slash costs & capex in order to preserve free cash flow. However, this can't continue and Harnett expects employment to pick up in the near future (see chart of claims [lagged 6 months] & unemployment). This, will also increase monetary velocity.
              Asset prices are rising across the board (he highlights the 14% annualised growth in UK house prices over the last 3 months as well as the rise in the oil price). This combined with the fact that the Bank of England appear to be targeting nominal GDP growth of +5% (MPC member Charles Bean Feb 09 speech re targeting "growth in overall economy of circa 5%"). A focus on price levels of assets such as house prices will keep policy looser for longer. The BoE will therefore tolerate much higher CPI in order for prices to get back to pre crash levels.

              Inflation will appear in asset prices before consumer prices, which will be the catalyst for rising yields (e.g. US 2 year currently below level of US core CPI, a relationship that will not hold for much longer).

              So there you go. Please excuse my crude attempt to distil such complex arguments and make your own mind up.

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