As the debate between inflationistas and deflationistas appear about to rev up again, I thought that I would try to pen to virtual paper and sketch my thoughts on the matter.
The specific catalyst for looking into this is naturally in part, the fact that oil looks set to do a round of catch-up with the rest of the frothy commodity space, but also this piece by the Pragmatic Capitalist citing David Rosenberg on the coming deflationary shock;
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.
I think Rosey has this one spot on. The risk of rising oil is not a hyper inflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today’s Case Shiller housing report for instance).
Hang on a minute then. Do you mean to tell me that we have been running around worrying about QE2 leading to bubbles all over the place, while the real danger is continuing and entrenched deflation? Well, yes this exactly what this means, but note the important distinction between the US (and the OECD) and emerging markets. Greed and Fear kicks off this week with the following point ;
(...) an oil-led commodity spike would clearly cause an intensification of the current inflation scare which has been hitting Asia of late with India the most vulnerable market. Still, as occurred in 2008, such a spike is likely to have the perverse effect of short circuiting the inflation scare in terms of duration. This is because sharply higher oil and food prices will hit current growing optimism on the US recovery. For ordinary Americans are not seeing the income growth to offset such prices increases.
This point is echoed in BCA's chief economist Martin Barnes' recent report which exactly sets out to clear up the (non)-threat of inflation in the global economy.
Despite investor angst, the above analysis paints a relatively benign inflation picture for the developed countries. The policy mix of large fiscal deficits and highly stimulative monetary policies certainly appears inflationary. However, there currently is no excess monetary growth, and the pass-through from higher commodity prices is weak given ongoing slack in the economy.(...)
The emerging economies are in a very different position [from the OECD]. All three approaches to inflation are telling the same story: There is excess money growth and the absence of slack implies that higher commodity and energy costs will push up wages and the overall prices of goods and services. Thus far, inflation is edging higher, not spiraling out of control. Nevertheless, policymakers need to get ahead of the curve by raising rates and, where necessary, allowing exchange rates to appreciate.
A large part of Barnes' analysis is based on the notion of slack and thus the most illusive of all macroeconomic concepts, the output gap. But the argument is really quite simple. For cost push inflation to lead to higher overall inflation, there must be an inbuilt tightness in the economy for this to happen. That is to say that workers must be able to pass on rising prices to larger than expected increases in wages, and firms must observe strong final demand in order to be able to pass on the increase in prices to consumers. Barnes' argument in a nutshell is that while capacity constraints might be an issue in the emerging world, it isn't in the OECD still mired by a balance sheet/deleveraging recession.
This argument is interesting in relation to the notion of unintended consequences from low interest rates in the developed world and just what output gap central bankers should look at then. Enter James Bullard, president of the St Louis Fed and the discussion (hat tip FT Alphaville) of the global output gap, vis a vis the US output gap.
This argument combines the two points made by Barnes in the sense that while the analysis of the US economy might certainly merit low interest rates for a long time given the excess slack of the economy, Bullard explicitly mentions the potential of adverse effects from ZIRP at the Fed due to an increasingly neutral to positive global output gap. Here is the FT's John Kemp with the gist of Bullard's speech as he sees it:
It is the first time a senior official at the U.S. central bank has acknowledged global capacity issues rather than a narrow focus on U.S. unemployment and capacity utilisation might give a better indication of where inflation is headed.
The obvious question here is whether the US should care at all about global capacity issues, but given my endorsement of Rosenberg's point noted above, I obviously think they should. A central bank can argue up to a point that rising headline inflation should not be a reason for assuming a rise in underlying inflation pressures, but it is evidently obvious that as if an oil price rising to 120-150 USD (even for a short while) becomes a trigger for an even stronger deflationary shock, then the original argument for low interest rates becomes very difficult to make.
And finally, just to make sure we get all sides of the argument, we should never forget that stagflation is also looming as an increasingly likely outcome in parts of the global economy (hat tip: Global Macro Monitor).
Historically, the margins of retailers and manufacturers have been remarkably stable, says Carsten Stendevad of Citigroup’s corporate-advisory arm. If commodity prices continue to rise, they will eventually be passed on to consumers one way or another. After years of goods getting cheaper, consumers may have to start getting used to everyday higher prices. (quote from the Economist)
This highlights a crucially important issue, namely the underlying trend of inflation in the global economy. It stands to reason that if the trend of global headline inflation is up due to structural capacity issues, an increased prevalence of adverse supply shocks and low interest rates, then bouts of headline price volatility may incrementally find its way into core prices and in a deleveraging world facing the effects of a balance sheet recession this is tantamount to stagflation.
What is the take then?
If the small tour above of the informed punditry serves to set the stage for general argument, what are then the important points to take away? Below I offer my suggestions:
The stronger the melt-up, the stronger the correction. This is a classic dictum in the world of finance and translated into the inflation vs deflation debate. It means that the stronger and longer the outbreak in commodity prices last, the larger the risk of a deflationary correction and we are then talking about a re-run of 2008. It also raises important questions regarding the policy tools used by global central banks. Bernanke and co can hardly claim, ex post after the crash, that they were right not to react to rising headline inflation when it stands to reason that the low interest rates were the main source of the commodity melt-up in the first place (and indeed will also be the source of the next melt-up a couple of years from now). In this sense, it almost amounts to a self-fulfilling prophecy that as the wall of lingering inflation and stagflation rise to a zenith, you also know that the time is nigh for the correction.
- Where is the capacity? Bloomberg recently ran a number of stories pushing the story that while emerging markets were the strong performers in the immediate wake of the crisis, the fortunes were now turning to the US and developed markets. On the surface, this is undoubtedly true and a rotation out of emerging markets into developed markets remain the main consensus trade at the moment. Structurally however, this masks a more fundamental question of the so-called emerging economies' ability to sustainably absorb all the excess liquidity and savings which is trying to find an outlet. The evidence from 2008 and the current melt-up suggests that while the long term story of emerging markets as the new drivers of global growth remains intact, this is not a linear process. Indeed, we are presented with some grave questions as to the collateral damage from the process of global rebalancing that is bound to take place. Some part of the immediate inflation issues could perhaps be solved by allowing a more gradual appreciation of a broad basket of EM currencies to the USD, but this then pushes the problem further towards the question of just what magnitude of external borrowing the emerging world can be expected to do to transfer growth to ailing economies in the OECD. In addition, there is a real risk that higher interest rates coupled with an open capital account would lead to an exacerbation of hot money inflows.
- Volatility around a Trend? One of the most crucial questions to answer in this debate, is whether the underlying trend of prices is one of inflation or deflation in the developed world. Based on the reaction by monetary and fiscal policy makers they squarely believe in the former. But volatility has a cost independent of the trend around which it operations. Given that we seem to be looking at a re-run of 2008, it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimized is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend, to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome. Could it be that we are then talking about two trends here? One which is the underlying structural forces of deleveraging, and the second is the structural issue of too much capital chasing too little yield proxied by the fact the growth to fight deleveraging must largely come from external sources.
- Stagflation coming to a town near you? As I am currently living in the UK, I think I am as good as any to talk about the spectrum of stagflation. Whether or not you agree with the BOE in its rather complacent view of inflation (given its own inflation target policy mandate), it seems to me that the UK citizens may be the first in the OECD to really experience what a hike in indirect taxes as well as rising global commodity prices mean. Again, you could of course note that if this all ends in a deflationary implosion, in the end it is a matter of semantics, but these are then semantics which matter. More generally and going back to the point made by the Economist, if the general trend in global headline inflation for structural reasons is up, then one would find it hard to believe how this would not act as a stagflationary trend in a world where demand, pull, inflation and growth are kept at bay by deleveraging. I want to see entrenched prices before I believe it, and I still concur that this is playing out largely as in 2008 (with a deflationary outcome), but in some economies it might be different and the UK is a good candidate.
- Inflation today, deflation tomorrow? The extent to which we are watching a rerun of 2008 is still to be seen, but I also think that the further we get down towards the path where low interest rates become structural parts of the macro picture, we run the risk that inflation expectations get entrenched. I am not talking about the global economy as such, but perhaps about individual economies. The divergence between those still stuck in deflation and those experiencing stagflation is a dangerous cocktail.
- Kill the speculators!? I remember during the heated days of 2008, a large part of the observed punditry slowly but surely came to the conclusion that high commodity prices were here to stay, and that obviously speculation had no hand at all in this. Apparently, if oil prices went up 100% over the course of 6 months, then it was all a question of fundamental supply and demand. Like Fischer and his famous remark on US stocks reaching a permanent plateau, it lasted until it didn't. In short: Obviously speculation plays a part. I would have thought this to be blatantly clear. Commodities of all forms and kinds have been thoroughly securitized which is exactly what allows such a melt-up in the first place. But this does not mean that the speculators should be lined up and shot, let alone that they are a force of evil. I any case, what speculators are you talking about here? What about China (and other sovereigns) stockpiling commodities and in turn, bidding up prices? Should these be regulated and how? And if you really want to have a go at the masters of the universe of Wall Street and the City, would that really change a thing? Speculation in the form of what Sarkozy et al talk about is a phantom menace, and the real issue here is more structural. But speculation ... indeed, lots of it! Finally, I should note that this time around we have had a number of concurrent and severe supply shocks to especially soft commodities which clearly have exacerbated the melt-up. Further, the extent to which adverse weather phenomenon become more prevalent will add volatility to the commodity edifice regardless of what markets and regulators do.
Which door should you pick then to get it right on the global economy? You would not be surprised if my answer here is ambiguous. At the moment, I am leaning towards a 2008 re-run, but precisely because it appears to be a re-run raises some additional important questions. Consider then the following from one of my friends:
The underlying problem is that the Emerging Markets as a group (while many of them are long term growth positives) simply cannot withstand the short term massive funding injection without food prices getting out of control. Food prices getting out of control produces, as we are seeing, political instability, and this leads investors to withdraw.
As noted above, this is then a issue of short term capacity to add as magnets of yield, as well as long term capacity to rebalance the global economy. But this is the trend then. Speed and volatility matters too as another of my friends pointed out:
I think rates of change in oil price matter a lot more than the level. People adapt, but they can't adapt quickly. We need to watch the speed of the oil price as it moves. If it moves quickly, that could be a huge drag on growth like 1980, 1991, 2008.
I think these two arguments combined are very, very important. I would hold lingering deflation to be a near certainty in the European periphery and Japan, where it never left. I also see many of the worst affected economies in Eastern Europe suffering a deflationary outcome. In the US, we will see and in the UK stagflation is a real threat if only because inflation may soon feed into expectations on a sustained basis.
Emerging economies as a whole will be fighting inflation for a long time to come especially as the hunt for yield continues. In the end then, picking which door to choose may depend as much on your time frame and unit of analysis as anything else.