Everywhere you look at the moment inflation is a hot topic. Or is it?
“In everyday usage, these expressions (ed. inflation and deflation) are based upon an entirely untenable idea of the stability of the value of money, and often also on conceptions that ascribe to a monetary system in which the quantity of money increases and decreases pari passu with the increase and decrease of the quantity of commodities the property of maintaining the value of money stable.”
Ludwig von Mises
- There is a strong correlation between recent short-term spikes in commodity and food prices, an increase in media reporting about inflationary risks and elevated short-term inflationary expectations.
- Focusing on the near-term however makes little sense to institutional investors with long-term horizons.
- Central banks see limited medium term risks to the upside for core inflation and money supply growth remains week (M2 growth in February is up 2.5% year-on-year).
- The current frenzy of reporting over commodity and food price shocks is prompting investors to review their asset allocations and potentially accelerate moves to make portfolios more inflation resistant over the long-term.
Let’s take a quick look at social media, what the central banks are saying and what the press and investment community are writing about.
Run an inflation search on Twitter and you will receive a sea of entries. But do a search on Google Trends and you will not see a particular increase in searches for inflation as a topic (top graph). You will however see a clear spike in the number of news stories (bottom graph). Blue is inflation while red is interest rates.
The Central Banks
Let’s take a quick look at what the Central banks have been saying.
The Fed has been clear in expressing it’s view that the recent increase in headline inflation has been driven by cost-shocks from higher retail gasoline prices as well as the prices of non-fuel industrial commodities. The Fed sees these price increases as transitory and not bleeding through to core inflation (which strips out volatile food and energy prices) or its preferred price index for personal-consumer expenditure (PC) which is based on actual monthly outlays (not the CPI’s household survey).
The Fed’s economic outlook also stresses that financial markets as well as market surveys are indicating an increase in short-term inflationary expectations (in the 1-5 year range) but not at the long end of the curve (the Fed’s preferred measure is the 5 year forward break-even rate i.e. 5-10 years out). The minutes of the Fed’s March 15 FOMC meeting include this statement:
“Sizable increases in prices of crude oil and other commodities pushed up headline inflation, but measures of underlying inflation were subdued and longer-run inflation expectations remained stable.”
The Minutes also make clear that wage pressures remain muted and resource utilization slack.
Meanwhile the President of the ECB stated on April 7 that an increase in energy and food prices, greater than expected global trade levels and elevated global liquidity creates continuing risks to the upside for HICP inflation (the harmonized EU wide inflation measure) and potential second order effects (i.e. price and wage setting behaviours).
The Bank of England meanwhile is predicting inflation of above 5% in the near-term and expectations of higher volatility in prices in the medium-term perhaps due to perceptions of more frequent cost-shocks (e.g spikes in oil prices). The BOE’s outlook however stresses that inflation is likely to drop back below target as short-term oil and food price shocks dissipate and overall weakness in economic activity/ spare capacity and limited upward pressure on wages persists.
According to the People’s Bank of China’s official website, the broad money supply has increased 15% year-on-year (but this is 20% slower than last year!). PBC has raised reserve requirements for banks 9 times since the beginning of 2010 and benchmark deposit and lending interest rates 4 times since October.
The Reserve Bank of Australia has a ‘mildly restrictive’ monetary policy setting in place (and the western world’s highest official cash rate) which takes into account a mixed economic outlook (a multi-speed economy with strong private investment in the resources sector but diminishing private investment and credit-growth economy wide, lower wage pressures and some skills shortages at near full-employment). The RBA sees temporary extreme weather related supply and cost shocks abating in the short-medium term and an inflation rate settling down within the target range (2-3%).
The Swiss National Bank is maintaining its expansionary monetary stance in the face of strong domestic GDP growth, increasing technical capacity utilization and increased hiring. This is in part due to a weakening outlook moving ahead due to lost competitiveness from the appreciating Swiss franc and a drop in tourism revenues. The SNB’s conditional inflation outlook clearly sees risks to the upside for price stability and a likelihood of monetary tightening in 2012.
Leaving China aside there appears to be strong consensus that current pressures to headline inflation and a spike in inflationary expectations are caused by temporary factors that will subside in the short-term. Strong ties to the global recovery as well as exchange rate and labour market pressures in Australia and Switzerland underlie their more cautious outlooks.
The FT has reported extensively during Q1 on increasing inflationary expectations (as represented by break-evens on the 5 and 10yr in the U.S., U.K. and Germany). It has also looked at the correlation between forecast inflation and Presidential elections (a 1% increase in inflation on some measurements leading to a 2/3rds of 1% decrease in vote share). The WSJ has written about rising shelter costs feeding through to core inflation (about 40% of the CPI based on rents not mortgages) and imported inflation from emerging markets. Divergent comments made by Fed officials have received significant attention. Much has been made of rate rises in China, India, Brazil, Chile and Peru. Editorials have focused on the limitations and biases of various inflation measurements.
The financial press has of course exhaustively covered the potentially inflationary impact of massive quantitative easing programs in the U.S. and the U.K. These programs are being finalised against a back-drop of sharply rising oil prices and turmoil in the Middle East and North Africa. We can all see the exchange rate adjustment underway and wonder if this is part of the way out of the fiscal quagmire the developed world is stuck in. It is not surprising that financial market as well as survey measurements of inflationary expectations have spiked at the short-end of the curve. There has been very little attention given to the relatively weak growth of the money supply.
The jury is still out on whether quantitative easing will lead to sharply higher inflation over the medium-term. While the private sector continues to deleverage and commercial banks’ cash balances continue to edge higher, inflationary pressures through excessive monetary or credit growth would seem unlikely to result. Unemployment remains elevated, capacity utilization slack and wage pressures muted to boot.
Von Mises (above) warned us not to fall into the trap of assuming that monetary stability is the natural order of things. He went to on argue that we should focus our attention more on large changes in the quantity of money evoking BIG changes in the objective exchange value of money. It’s hard to do this during a news blitz that is not focused on money suppy growth. Nontheless as Allan Meltzer has pointed out, the biggest risk is that the Fed waits too long before it begins tightening. “There is a long lag, up to two years, from the beginning of anti-inflation policy to success.”
So we are not searching ‘inflation’ more as a topic on Google, Central Banks are generally relaxed about the long-term outlook for inflation, and we are definitely reading more about the topic in the media. This is impacting our expectations of inflation in the short-term. In turn this may be prompting investors to reassess their asset allocations.
Casey Quirk put out a thoughtful survey based white paper each year together with evestment Alliance. The April 2011 paper is based on responses from 55 investment consultants representing $10.4 trillion in assets. It is thus a good snapshot of the entire institutional investor community. Unsurprisingly Casey Quirk sees a move towards more outcome-oriented porfolios and away from simple asset allocation models. Here is a brief excerpt from that paper which you can find here http://bit.ly/f9spFe
“Inflation appears to be the most influential factor driving institutional investors to separate portfolios into return-seeking and risk-mitigation allocations, rather than simple splits between stocks and bonds. As in 2010, more than 80% of surveyed consultants believe inflation protection will either be a significant or a moderate focus of search activity during 2011; more importantly, more than one-half of consultants believe search activity related to inflation risk will increase over 2010 levels.”
Investors have been structuring more inflation resistant portfolios for some years – particularly through allocations to real assets – I would argue that the 2010 and 2011 surveys are picking up some increased urgency in searches in the wake of recent price shocks and lingering concerns regarding inflationary risks associated with massive government intervention (QE as well as fiscal and regulatory policy) in the economy in the wake of the 2008 financial crisis. I will look at real assets in more detail another time.
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