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Inflation or Deflation?

Early this year, I advocated building exposure to long-term inflation hedges such as TIPS and resource equities, because they were radically mispriced as investors fled in fear of a sustained deflationary environment. That strategy played out well, and TIPS are now implying around 2% CPI inflation over the next decade, or broadly in line with experience in the last. We face a tug of war between inflationary and deflationary forces in coming years, and key to the outcome will be the scale of excess liquidity (ie a rising money-to- GDP ratio) and how swiftly it is drained from the system in a recovery. Currently, the huge expansion of central bank balance sheets hasn't translated into higher credit via the banking system and therefore a broadening of money. In other words, the velocity of money remains very subdued as banks focus on deleveraging (with the exception of China). This can be seen by the remarkable 6% of GDP parked at the Fed as reserves by US commercial banks, and similar bank risk aversion is evident in the UK and Europe.

Monetary policy has been astonishingly loose for most of the past decade, in response to a series of financial panics starting with the 1998 LTCM/Russia meltdown, proceeding via the IT bubble bursting in 2000, and now the systemic banking crisis of 2008. Ironically, like a doctor feeding an addict's drug habit with ever higher dosage, the response to each crisis has precipitated the next. Between 1996 and 2009, nominal GDP in USD for the top five global economies grew 60%, but narrow money (M0) grew 230% and broad money (M2) 210%. Much of the excess leaked into a fast sequence of speculative bubbles from Internet stocks to Florida condos and oil futures. You can picture the current monetary situation like a dam, with a lake of fresh money rising even higher, held back only by weak supply (and indeed demand) for credit.

When that dam breaks, and credit growth resumes, even at much lower levels than seen in recent years, the inflationary risks become substantial. There is now intense political pressure on banks to lend, as a quid pro quo for their generous taxpayer funded bailouts. When looking at inflation, it is a mistake to consider it simply in terms of narrow CPI statistics (which are in any case arbitrary in their calculation. Volatile asset inflation has been a characteristic of the last decade precisely because the real economy hasn't been able to absorb the flood of money issuing from central banks and amplified by a secular rise in bank leverage until last year's crash. Historically, a big rise in money supply takes 1-2 years to inflate asset prices. However, given the unique nature of quantitative easing which involves creating money to directly buy assets such as bonds from institutions, thus providing fresh capital which they can re-invest into riskier assets, the lag this time has been a matter of months rather than years, and is being reflected in the relentless rally in equities.

When looking at 'excess' liquidity, there are three distinct sources. Firstly, the Greenspan era monetary indiscipline, secondly global balance of payments imbalances (notably between China and the US) and lastly FX funded carry trades (where hedge funds etc borrow money in a low yielding currency like the Yen and invest it in higher yielding ones like the NZ/Aus$). A key problem of rapid globalization is that banking systems in key emerging markets simply haven't been sophisticated enough to absorb the trillions in trade surpluses accululated from merchandise and commodity exports, and that surplus has been recycled back into Western financial markets. That problem is made worse by China's efforts to suppress its currency by keeping its over $2trn in reserves offshore in Treasuries and other assets. In the very short term, shrinking trade surpluses and less aggressive carry trade activity has helped the deflation case, as much as the tattered state of bank balance sheets.However, there are already strong signs that both are reviving (with the dollar replacing the Yen as the 'borrowing' currency of choice), thus turbo-charging money growth in 2010 if central banks wait too long to take their economies off life-support. If the Fed and BOE follow Sweden's recent example in applying zero or even negative interest rates to bank reserves they hold, it will accelerate the release of that money into the real economy.



The fact is that in output terms this has only been a pretty typical cyclical recession for the global economy, and having been slow in 2008 to recognize the clear signs of credit system stress, central banks and governments then over-reacted to attempt to fully compensate for the slump unsustainable private sector credit growth. New asset bubbles (and one is probably forming in Asia ex Japan) will be the initial manifestation of an inflationary breakout. Overall, while deflationary forces predominate into 2010 given the scale of spare capacity, even a muted recovery and a modest pick-up in money velocity are likely to generate the highest inflation levels since the early 1980's on a 3-5 year view, after a decade of monetary incontinence.

Disclosure: None