Inflation has been in the headlines in very recent weeks, with lots of people finally worrying that inflation was rearing its ugly head, central banks tightening interest rates, and commodity prices (despite last week's drop in prices) running higher and higher.
My impression is: it's too late to do anything, because we've had de facto inflation for the past 10 years - in the form of a long series of asset bubbles, now finally mutating into "real" inflation. Today's inflation is just a late symptom, and treating that consumer price inflation will certainly not solve the underlying problem.
See also bonddad's diary on stagflation.
Here's the problem:
Over the last 10 years:
Over the last 25 years:
We are basically at the end of a very long bull market. And what people forget is that this was first and foremost a bond bull market:
(Prices of bonds go up when interest rates go down: if you have a peice of paper worth 100 and giving you 16 per annum, you are willing to pay a lot more than 100 for it when interest rates are at 4% - something close to 400, as the annual 16 payment gives you the desired 4% return. The real calculation is a bit more complex, but you get the idea).
And in recent years, that bull market has extended to all sorts of asset classes: real estate as we all know, but also corporate debt and emerging markets debt, where the increase in bond prices has been even more spectacular in a few short years:
As I've written before, ultra cheap money, provided first and foremost by the central banks of Japan and the USA, has made debt easy, but has correspondingly made asset more expensive in that de fact odevalued money.
Starting in the mid- to late-90s, that process went completely overboard:
The USA started using debt to consume - and import - goods. That dangerous use of debt was made painless by the low interest rates and the feeling of prosperity created by the correspondingly inflated prices of assets like bonds, stocks and houses.
Which gets us back to our graph above the fold:
Oil and gold prices seem nicely correlated to inflation; if anything, the above graph actually underscores the threat, as the CPI makes the oil price increase look more innocuous than if you use other, more relevant index to deflate the price, like industrial prices or export prices:
Martin Wolf, the senior economist of the Financial Times, is seriously worried as he quotes a recent study (pdf) from the BIS (Bank of International Settlements, the central bank's central bank):
The contemporary combination of high to very high valuations of real assets (such as housing and equities), low spreads of risky assets over risk-free ones (such as emerging market and corporate bonds over US Treasuries), rising real prices of commodities (notably oil) and huge shifts in patterns of saving, investment and finance around the world (shown in the global "imbalances" and rising indebtedness of household sectors, notably in the US) is good reason for nervousness.
Why have markets reached their exposed position? The answer is that success breeds excess. This is the argument of a fascinating new paper from William White, economic adviser to the Bank for International Settlements.
Mr White argues that a monetary policy aimed at stabilising inflation in the medium term may well be destabilising in the long term. Beneficial changes in the world economy - the fall in oil prices after 1985, collapsing prices of computing and communication, declining prices of exports of manufactures from China and liberalisation of economies - lowered inflationary pressures.
This justified accommodative monetary policies. But these helped blow a series of asset-price bubbles in liberalised financial systems, notably in Japan in the 1980s, in emerging market economies, particularly in east Asia, in the late 1990s and, finally, in the high-income economies of North America and Europe.
In a low-inflation environment yet more monetary stimulus was applied to deal with the aftermath of each asset-price collapse. Ultimately, however, inflation or large-scale write-offs may be required to bring the value of income, assets and debt back into line.
One thing, as Mr White notes, history makes clear: "a preceding period of price stability is not sufficient to avoid serious macroeconomic downturns". High inflation did not precede the great depression of the 1930s, Japan's lost decade in the 1990s or the emerging market crises in east Asia in 1997 and 1998. What preceded all these extreme events were credit-fuelled investment booms in an era of stable inflation.
(...)
A "combination of technological change and deregulation has led to a quickening process of disintermediation from banks, growing reliance on market processes, globalisation and institutional consolidation. In short, we now have a liberalised financial system which seems much more likely to show boom-bust characteristics than the previously repressed one."
(...)Mr White explains booms and subsequent busts as follows: "Buoyed by justified optimism about some particular development, credit is extended which drives up related asset prices. This both encourages fixed investment and increases collateral values, which supports still more credit expansion. With time, and underpinned by an associated increase in output growth, this process leads to increasing willingness to take risks (`irrational exuberance'), which gives further impetus to the credit cycle; (...)
The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become. What happened to Japan in the 1980s is an example of this danger.
(...)
this process can continue for a long time, provided inflation remains low. The limit is reached only when inflation becomes a serious concern. That may now be the danger.
This makes the case, if that was ever needed, for the need to watch out not just for consumer price inflation, but also for asset price inflation, i.e. bubbles - exactly what "Bubbles" Greenspan's Fed did NOT do.
The result is here today. Inflation looked repressed, so monetary policy could remain easy and money cheap. Speculation ran wild, debt was used not to invest but to binge, and the alarm signals (inflation) were hidden by the relentless compression of prices and wages coming from the combination of the emergence of China in international trade and the ideological drive to say that only GDP and profits matter, and not wages or debt.
Well, hidden inflation is bursting on the scene now. Via commodity prices. Via staggering inequality. Via massive trade deficits and imbalances. And now as plain old inflation.
But this is just the last symptom. Fighting inflation now (by increasing interest rates) will only accelerate the bursting of the bubble - making debt more expensive will wreck the balance sheet of certain countries, many investors and more households. Not fighting it will lead to the same result as inflation is just a sneaky way to default on one's obligations and debt will get more expensive by market mechanisms rather than by fiat.
Crunch time is definitely getting closer.