Tuesday, April 13, 2010

Ten Observations On Risk Of Rising Inflation

Ten Observations On Risk Of Rising Inflation
How Will We Handle The Reversal Of Secular Trends That Have Spanned Decades?

By James Kostohryz | 6 April 2010

Due to other commitments, I'll probably be posting less often in the next few weeks. However, I don't want to fail to address one of the potential implications of my bullish predictions on growth outlined in my last three articles— Economic Growth Could Get Scary, Global Trade Data Suggest US Growth Surge, Evidence of Impending US Growth Surge— that is the potential for an inflation scare. Aside from the short-term cyclical risks associated with a sharp acceleration of US and global growth, it is my view we are on the verge of important secular shifts in various areas that will profoundly affect inflation dynamics in the next decade.

I'll only outline a few relevant points here which I hope to be able to elaborate on further at a later time.

1. Forget about monetary aggregates. Contrary to popular belief, monetary aggregates are of little to no use for forecasting inflation.

2. If anything, monetary aggregates point to disinflation/deflation. Contrary to popular beliefs, if monetary aggregates were of any use at all, they would currently be suggesting low inflation or deflation. Whether measured by M1, M2, M3, or MZM, the 12-month rate of change in the monetary aggregates have been either growing at a pace well below the average of the past two decades of low inflation, or are outright contracting.

3. Fed actions are not inflationary. Contrary to popular beliefs about Fed "money printing", the actions of the US central bank in the past year have not been inflationary. Virtually all of the Fed's expansion of its balance sheet has been sterilized[1] and therefore poses no inflationary threat in the short— to medium-term. Thus, the inflation risks of the current cycle have almost nothing to do with the recent actions by the Fed.

4. Commodity price risks. The most immediate inflation risk relates to the price of international commodities such as oil, steel, copper, and the like. The Fed, and the US in general, has virtually no control over these global markets. US demand for most commodities, even under an optimistic growth scenario, will be inferior to the overall rate of growth of global supply of these commodities.

This means that the US will generally be a net drag on global commodity prices on the demand side. The marginal demand growth for commodities is coming from emerging nations, and Asian countries in particular. Very strong economic growth there, combined with very loose monetary policies in those countries, will tend to pressure commodities' prices.

Given that demand is relatively inelastic and production capacity is fairly tight relative to current levels of demand in most commodities, strong global growth could provoke major spikes in commodities' prices as demand growth starts to overrun supply growth, and inventories start to shrink appreciably starting in the second quarter of 2010. Although the US economy has become progressively less commodity intensive over the years, synchronous spikes in commodity prices such as those that occurred in the 2003-2007 period could increase the annual CPI rate by three to five percentage points over any given 12-month stretch. The core CPI could also be affected by 1% to 2% with a lag in such a scenario.

5. Imported inflation. Throughout most of the 1990s and the first half of the 2000s, the US economy enjoyed the benefits of imported deflation, mainly from Asia, but also from Latin America. The devaluation of the currencies of these regions in real terms, combined with extremely strong productivity gains, caused the fundamental equilibrium exchange rate (FEER) of the US Dollar to appreciate to historically high levels. This caused a massive surge of import growth that not only substituted for domestic production at lower prices, but also prevented domestic producers from being able to raise prices.

I estimate that in the context of [more balanced] inflation differentials and a depreciating nominal exchange rate, a return to a fundamental equilibrium exchange rate in the US over the course of the next decade will imply a roughly 1.0% to 1.5% per annum increase in the core rate of inflation during this decade relative to last decade. This implies an average range for core inflation from 3.0% to 4.0% starting about 1-2 years from now.

6. Fed is helpless to contain imported inflation. Due to historically low levels of capacity utilization and extremely high levels of unemployment, inflation from core domestic sources in the US should be quite contained during the first two years of the current recovery. Virtually all of the inflationary pressures will arise from foreign sources and will affect mainly the tradable sectors of the economy.

The Fed won't be the cause of this type of inflation. Likewise, there will be virtually nothing that the Fed will be able to do about it. The return to a fundamental equilibrium exchange rate, and its inflationary consequences, is a process that simply must be allowed to run its course. It would be foolish for the Fed to try to counteract this with contractionary monetary policy.

7. Monetary policy risk. In the context of its mandate to promote full employment, given high rates of unemployment in the US, the Fed will be tempted to keep real interest rates low for an extended period. Thus, a repeat of the 2002-2005 experience of low real interest rates relative to the growth of GDP is a distinct possibility. Such a scenario poses inflationary risks for the economy including asset price inflation in certain markets. In particular, given my bullish outlook for growth in the next two quarters, I expect a spike in growth in the broader monetary aggregates (not so much in the narrower aggregates) and an expansion of the money multiplier— all functions of a rising demand for credit.

Furthermore, the so-called velocity of money (I consider this concept to be quite irrelevant, but many people swear by it) will accelerate with the uptick of economic activity— thereby provoking some alarm. Given that many financial market participants are still mentally beholden to discredited monetarist dogmas and the quantity theory of money more generally, this could produce much angst in financial markets. When it comes to inflation, perception is reality, as inflationary expectations have been empirically proven to be the single greatest driver of actual inflation.

8. Core inflation (ie, ex food and energy) should accelerate to an average of 3.00% to 4.00% per annum during the next decade, during years that the US economy is growing. In the aforementioned context of imported inflation, US CPI and core CPI inflation may remain uncomfortably high even during periods of recession in the US. This forecast is predicated on the US gravitating toward parity on a fundamental equilibrium exchange rate basis and on [reasonably] strong global growth outside the US, particularly in the developing world.

9. The broad CPI (including food and energy). Overall CPI will probably average between 4.0%-5.0% during most of the next decade, with brief spikes up to around 8.0% not unlikely.

10. Risks from US Treasury Bond market. An acceleration of the core rate of inflation to the 3.0% to 4.0% range suggests 10-year US Treasury yields in the 5.% to 6.5% range, with the possibility of some temporary spikes beyond that range. The real exchange rate adjustment mentioned earlier could pose further challenges to US Treasury bonds as foreign investors demand higher yields to compensate anticipated Dollar depreciation.

A rise in nominal interest rates of the aforementioned magnitude could be absorbed by the US economy if it is sufficiently gradual. As long as capital markets aren't seriously destabilized and the US economy continues to grow, corporate fundamentals in the US will improve. Therefore money should flow to non-treasury debt thereby compressing spreads which are still quite high, thereby mitigating the rise in the risk free rate.

Also, it is important to remember that it is ultimately real interest rates that really matter. If history is any guide, the rise of real yields on long-term debt should lag the rise in nominal yields. Such a scenario could actually prove quite stimulative to the economy in the medium term.


Make no mistake about it. The full implications of my predictions regarding accelerating cyclical growth and concomitant commodity price inflation, combined with the secular trend toward imported inflation, are quite profound, if not revolutionary. What I'm talking about is nothing less than the reversal of secular trends that have spanned two to three decades. Most people working in financial markets today have simply not known such an environment. It will be a shock.

The risks of commodity price spikes should be accentuated between April and September of 2010 and the broad CPI could surpass 3.0% by the end of the year. However, it probably will not be before mid 2011 that core inflation rates could break out of their 15-year range of approximately 2.25% to 2.75%.

The question is how exactly financial markets and policy makers will deal with these cyclical and secular developments. I think it would be foolhardy of me to make such a long-term prediction at this point. Such predictions can only be reliably made, if at all, once the ground starts shifting and one has been able to observe the initial reactions of policy makers and financial markets participants. A doomsday scenario is neither necessary, nor even likely. Furthermore, I can envision many scenarios in which the US economy does quite well in an environment of moderately accelerating inflation and rising nominal bond yields.

However, in the event that my predictions regarding cyclical and secular forces leading to higher inflation prove prescient, the situation will become quite fluid.

You could even call it scary.

As reported last week, I'm studying investment options such as: Long SPDR S&P 500 (SPY), PowerShares QQQ (QQQQ), and iShares Russell 2000 Index (IWM). Short SPDR Barclays Capital 1-3 Month T-Bill (BIL), iShares Barclays 1-3 Year Treasury Bond (SHY), or iShares Barclays 20+ Year Treas Bond (TLT).

Long UltraShort 7-10 Year Treasury ProShares (PST), UltraShort 20+ Year Treasury ProShares (TBT). Long SPDR Barclays Capital High Yield Bond (JNK) and iShares iBoxx $ High Yield Corporate Bd (HYG). Long PowerShares DB US Dollar Index Bullish (UUP). Old favorites such as Apple (AAPL) and Bank of America (BAC) could fly in such an environment.

Investment banks such as Goldman Sachs (GS) and Morgan Stanley (MS) should rock as underwriting activity and M&A heat up. The tech space in general looks very attractive including chips and networking. Economically sensitive cyclical stocks should do well but timing will be key as major events in the bond markets and China loom.

Brazil and Asia, excluding China and Japan, look particularly good in the emerging markets space. Finally, gold-based investments such as SPDR Gold Shares (GLD) and Market Vectors Gold Miners ETF (GDX) should remain in a sweet spot.

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