Inflation/Deflation & Interest Rates
The combination of this and today’s Bank of England rate setting meeting got me thinking about inflation.
My own views are quite nuanced and have varied a bit over time, so bear with me whilst I outline them below and please remember that for much of this time I was talking about the developed economies as a whole rather than just the UK.
Back when I worked in fund management, I was reasonably convinced from mid 2007 onwards that deflation not inflation would was the primary challenge facing the developed economies. I was more worried by the fallout from the credit crunch that been developing since June 2007 (when two Bear Sterns (remember them?) hedge funds had collapsed on sub-prime losses) than about inflation, as I told the IHT at the time:
Inflation, a concern several months back, has been drowned out by the collapse in the market for U.S. mortgage debt and the slump in confidence caused by seizure of the credit markets. That is not to say inflation has disappeared; it is just not as malignant as many observers would have us believe.
The credit crunch poses a bigger threat to markets than inflation. Bank-lending policies have been loose, and it is difficult to analyze the content of balance sheets and counter-party risk with any degree of confidence. We are moving client portfolio weightings in financials to near zero, and switching into the telecommunications sector where we see value.
The one thing that can be said with any degree of certainty is that the situation for the U.S. consumer can only get worse. So far, $197 billion worth of U.S. mortgages have been reset this year. This is significantly less than the $521 billion that is to be reset in February and March 2008.
As I saw it the impact of a collapse in bank lending would be a contraction in demand which would offset inflationary pressures.
I stuck to this view throughout 2008. As commodity prices soared and headline inflation picked up this became a somewhat uncomfortable experience, but I was eventually vindicated from Autumn 2008 onwards.
I started blogging back in March 2009, so there is a better paper trail of my views from that point on, for better or worse… I wrote back then of how I was worried about the prospect of a deflationary spiral and pointed out the instances of deflation around the world. I also noted that Sterling’s large fall had helped the UK avoid deflation.
By May 2009 though my views had shifted away from an outright risk of deflation, partially due to the actions taken to avoid it. At this point I began to speculate on the possibility of the UK experiencing both inflation and deflation.
I returned to this theme in September last year. And I stand by what I wrote then:
But – energy prices (maybe driven by supply constraints) are increasing and are likely to continue to increase.
Similar issues with food (see this http://ftalphaville.ft.com/blog/2010/09/17/345981/china-1789-and-potash/ )
Possibly cotton to (which feeds into clothing, see Primark warnings the other day http://www.google.com/hostednews/ukpress/article/ALeqM5iCpYY9BEsMGEPKWk74528tL3-U4g ) although maybe that one is possibly short term.
We basically have a trade off between rising primary product costs, which is likely to continue, and stagnant wages.
Plus a general lack of corporate pricing power across the West as consumers are over stretched.
I would not be at all surprised if we ended up in a situation whereby core inflation (i.e. excluding food and energy) was falling but headline inflation remained broadly positive (even 3/4% or so).
This becomes self perpetuating. Given the low elasticity of food and energy demand, rising prices here act as a tax on other consumption, further reducing demand and further reducing prices.
We then have the worst aspects of deflation – falling corporate profits and probably rising unemployment, without the benefit of rising real wages.
The only point of this I’d revise now would be to say – we possibly have headline inflation of up to 5/6% in 2011.
As I wrote in September:
Interesting to see how central banks play it. I’d have thought they need to concentrate on core inflation here – keep interest rates low. You can’t solve a supply problem with interest rates!
If they panic about headline inflation and raise rates (certainly possible), then the entire macro picture becomes even more scary.
I stand by that to. UK inflation is being driven by global commodity markets and VAT hikes, there is very little that the Bank of England can do to stop this. Any rate hike today or in the coming months risks disaster.