Wednesday, 27 August 2008

Inflation expectations lead to more inflation, right?

Generally it is argued that rising inflation expectations will lead eventually to higher inflation. Hence, it is no surprise central banks are monitoring such expectations closely and typically will raise interest rates if such events occur. Globally, inflation expectations have shot up - primarily driven by rising energy and food prices.
Thus, should central banks repeat the standard response by tightening their monetary policies? Larry Hatheway, chief economist at UBS, does not think such a policy would necessarily be such a good idea:
"Ever since Milton Friedman's address to the American Economic Association in 1968 and the ensuing theoretical work by Robert Lucas and others in the 1970s, the mantra - at least among central bankers - has been that rising long-term inflation expectations inexorably lead to higher inflation.
The central question is not about inflation expectations, per se. Nor is it about commodity prices, however quickly they may be rising. Rather, inflation is determined by the interplay between monetary conditions and capacity in the economy to grow without pushing most prices higher. That is where the story gets more complicated. Are monetary conditions easy? Is there spare capacity?
In the US, slack is appearing in the economy, as seen in rising unemployment, now up to 5.7 per cent. Negative real interest rates suggest monetary conditions are easy. But the Fed's own surveys suggest that bankers are less willing to lend; consumers less willing to borrow. Low real interest rates are a manifestation of economic and financial malaise, not excessive monetary accommodation. Altogether, the case for accelerating US inflation looks weak in the face of below-trend growth and stuttering credit conditions.

In the UK, consumer borrowing is falling sharply, the housing market is following its US counterpart into deflation, and consumers are retrenching. Here too, underlying inflation pressures ought to moderate.

In the eurozone, the picture is less clear. Money and credit growth have remained in double-digit territory and economic activity has been robust in recent years. Some signs of higher wage settlements are evident. But the most recent data also point to a sharp slowdown in the eurozone economy.

So, what are we to make of higher inflation expectations in the US and western Europe? Investors and households seem to believe energy and food prices will continue to rise. But will other prices and wages automatically follow suit? Stagnating growth and tighter credit conditions suggest the opposite.

Perhaps that is why consumer confidence has plummeted on both sides of the Atlantic. Eating and driving are more expensive, but weak growth, rising unemployment, and fear of outsourcing are keeping most wages in check.

In short, households may say they expect higher inflation, but there is little they can do about it. The reality is they are experiencing falling real incomes and pinched balance sheets. That is hardly the stuff of overheating.
The Friedman-Lucas emphasis on inflation expectations was a model suited to different times. Central bankers no longer try to ramp growth by springing inflation surprises on unwitting workers. Unionisation has declined, automatic cost-of-living adjustments are rare, globalisation has reduced pricing power for most companies and bargaining power for most workers.
Today, advanced economies are confronted with stagnating growth, collapsing housing markets, slowing world trade, stressed financial systems, and weak household balance sheets. This is not the 1970s. Broad-based price and wage inflation is unlikely today. We should therefore be sceptical of the case for tighter monetary policies based on models developed in, and better suited for, a bygone era."
Quoted from: Hatheway, L., 2008. "An Inflation model from a bygone era" Published:, August 24

Saturday, 23 August 2008

Managing a financial crisis

Today's subprime crisis and resulting credit crunch is perceived by some analysts as the worst financial crisis since the 1930s. Typically, market analysts are drawing parallels with previous periods of economic distress where authorities made some gross monetary policy errors.
Back in the 1930s an excessively tight monetary policy led to a prolonged period of deflation, while in the 1970s a loose monetary policy caused inflation expectations to become unanchored, leading to a stagflationary economic environment. Thus, in order to avoid the same mistakes as in the past, analysts are calling for a level-headed approach.
"Now, with inflation rising, the popular parallel is not the deflationary 1930s but the stagflationary 1970s. In fact both analogies are misleading, precisely because market participants and policymakers are aware of this history. Their awareness means that financial history never repeats itself in the same way. Biochemists can replicate their experiments because molecules do not learn. Central bankers lack this luxury.

In the 1930s the critical mistake was the Federal Reserve’s failure to recognise its lender-of-last-resort responsibilities. The result was not just financial distress but the collapse of the US price level, which fell by 21 per cent between 1929 and 1932. Since demand for commodities, including food and oil, was inelastic, their prices fell even faster than the overall price level, causing distress among primary producers. And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation.
As US demand weakened, other countries saw their currencies become overvalued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

The Fed's response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.

What is the solution? Emerging markets need to tighten their monetary policy further to damp down inflation. They need to revalue against the dollar to fend off inflationary pressures coming from the US, just as they needed to devalue in the 1930s to protect themselves against US deflation. We have seen small steps in the right direction, such as the interest rate rises recently agreed by the Bank of Korea and Bank Indonesia, but more needs to be done.

The Fed’s position is harder. If it now tightens, it risks compounding the recession. If it fails to do so, it risks undermining confidence and precipitating a dollar crash – which could still happen, in spite of the recent relief rally. Here the historical analogy is direct. In the 1930s the US needed expansionary policies to counter the depression but worried that moving too aggressively would demoralise markets and destabilise the dollar. Franklin Delano Roosevelt personally oversaw the process, setting the new dollar exchange rate each morning while taking breakfast in bed. In hindsight, his judgment looks sound.

One hopes that history will judge the Fed as favourably. James Bryce, the historian, had it right when he wrote that the chief practical use of history is to deliver us from plausible but superficial historical analogies. Or as Mark Twain more prosaically put it, the past may not repeat itself, but it rhymes."
Quoted from: Eichengreen, B., 2008. " The Fed can learn from history's blunders" Published by, August 18

Tuesday, 19 August 2008

Michael Phelps' Gold Triumph, But Not In Value

Michael Phelps should be considered as one of the best athletes of all times after his winning streak of eight gold medals at this year's Olympic Games. But while on the topic of gold, another major event transpired during the past couple of weeks, namely some significant price reversions in precious and base metal prices.
"In the past month, as the Olympic games featuring the famously ambitious US swimmer got under way, the value of the metal awarded to winners has slumped by a fifth. Runners-up, as usual, fare worse, with silver down almost a third.

The proximate cause is the US dollar’s rebound. In the past year, gold and its silver sidekick have moved inversely with the greenback. The violence of the shift suggests other factors are also at work. Crude oil is one, with the commodity-in-chief’s own rapid decline possibly forcing some to liquidate metals positions.

The wider issue is that, when even war in Georgia fails to lift prices, commodities markets as a whole appear angst-ridden.
Indian brides are shunning gold jewellery, with demand falling 41 per cent year on year in the second quarter, according to Lehman Brothers. Even China’s supposedly inexorable march to mass middle-class prosperity is not immune: growth in sales of SUVs and light trucks there slowed last month to its lowest pace in two years. Meanwhile, Congressional ire against “speculators” continues to mount.
Metals are not doomed to fall in unison from here, with geopolitics, currency moves and the relative performance of financial markets all having a say. But the drumbeat of demand destruction is becoming deafening. Simply going long and holding on is looking ever less tenable."
Quoted from: Lex, 2008. "Metals and the dollar",, Published August 17.

Friday, 15 August 2008

Market Volatility

The past month (July 2008) must have been one of the most volatile ever seen by investors; not so much because the stock market overall retracted sharply, but rather the divergence in the performances of the different sectors of the market. For example, the resources sector plunged 19% in July, while the property and financial sectors gained 18% and 13% respectively!

It may well be that commodity prices, at least for now, will be under pressure with the prospects of a slowdown in global economic growth and strengthening US$. But then the rand may also become weaker and thus making those mining and resources shares attractive from a rand hedge perspective. Thus, do not necessarily expect the sharp downturn in resources stock prices to continue!