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.

Inflationistas have been smoking too much 'green shoots'!

After the recent deflation scare, inflation expectations have normalised (see chart below of UK 10 year breakeven inflation). Nonetheless, the 'inflation-deflation' debate continues. Indeed, inflationistas such as Marc "Dr Doom" Faber would have us believe that the US is headed towards Zimbabwe-style hyperinflation!


However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.


Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.


Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!

Interesting FT story on Germany's perspective on the possible economic aftermath

Germany warns on 'crisis after crisis'
By Bertrand Benoit in Berlin, 12 Apr 2009 10:57pm

The world could face high inflation and a "crisis after the crisis" when the global economy recovers, Peer Steinbrück, German finance minister, has warned.

The comments, in a weekend interview, are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments.

"I am concerned that the countermeasures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis," Mr Steinbrück told Bild, a tabloid daily.

"So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.

Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery.

German officials fear the liquidity being injected into financial markets could prove difficult to reabsorb, creating long-term inflationary pressure and, possibly, new asset price bubbles. "We do not have a short-term inflation problem," Mr Steinbrück said. "But in the medium term we must start thinking about how to pull the billions we are pumping into our economies out of the system again. This will be a special challenge for the central banks, including for the European Central Bank."

Because of its strong reliance on exports, the German economy has been one of the worst affected in Europe by the global economic downturn. It is set to shrink by 4.5-7 per cent this year and statistics published last week showed Germany had its lowest inflation in 11 years.

Peter Bofinger, one of the five top academics who advise the government on economic policy and, like Mr Steinbrück, a member of the Social Democratic party, said that Berlin's concerns about inflation were unwarranted. "Germany faces no risk of inflation for the foreseeable future. On the contrary, I see a clear danger of deflation," he told the Handelsblatt.com website.

Rising unemployment in the coming months would put wages under pressure, said Prof Bofinger, creating a potential downward spiral in wages and prices. Asked about how to fight the crisis, Mr Steinbrück conceded that there were "no intelligent alternatives" to higher public investments programmes. Unlike in the US, he said, there were no signs yet the German economy had turned the corner. "We are not through yet. Nobody can say if the worst is behind us."