cloud_zhou - 2008/7/2 14:43:00
The End of the Inflation Scare? by Louis-Vincent Gave
While most economists and strategists spend time worrying aboutgrowth, changes in inflation are usually a much greater driver offinancial markets than changes in economic activity. This is because:
1- A surge in inflation usually increases volatility of economicgrowth--which in turn reduces P/Es and the willingness of the privatesector to take risks.
2- As highlighted in The Myth of Reverting Margins,inflation typically takes a much meaner bite out of margins than arecession does. As we wrote back then concerning the US growth/marginrelationship: "Margins bear little relationship to the level of GDPor consumption growth. In fact, as the economy accelerated from themid-1960s to the early 1980s, margins plunged. Similarly, as theeconomy slowed from the early 1980s to the present, marginsaccelerated... It is inflation, not growth, which wreaks havoc onprofit margins (ironically, if everyone has pricing power, no one makesmoney).
3- Finally, a surge in inflation typically means interest rates willbe rising in the near future. Which means that investors get to losemoney on both bonds and equities. For example, from 1966 to 1980 (i.e.:the last "inflationary surge" period), US bonds shed -2% per annum andUS equities fell -4.9% per year.
Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat).And to be sure, growth almost everywhere around the world is slowingwhile inflation in almost every country is still accelerating.
Now everyone knows where the slowdown in growth comes from:de-leveraging in the financial sector, overextended consumers needingto tighten their belts, transfers of wealth from the private sector tothe public sector through high oil prices, etc... And there are ofcourse myriad opinions as to how long the slowdown will last. Butmeanwhile, on inflation, our clients seem to be much longer onquestions than answers. Where does the current inflation spike comefrom? How long is it going to last? And can inflation abate without a"Paul Volcker" like monetary policy from the Fed?
In this ad hoc comment, we aim to review some of these questionsand, as we always tend to do--answer these questions with yet morequestions of our own!
3- Finally, a surge in inflation typically means interest rates willbe rising in the near future. Which means that investors get to losemoney on both bonds and equities. For example, from 1966 to 1980 (i.e.:the last "inflationary surge" period), US bonds shed -2% per annum andUS equities fell -4.9% per year.
Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat).And to be sure, growth almost everywhere around the world is slowingwhile inflation in almost every country is still accelerating.
Now everyone knows where the slowdown in growth comes from:de-leveraging in the financial sector, overextended consumers needingto tighten their belts, transfers of wealth from the private sector tothe public sector through high oil prices, etc... And there are ofcourse myriad opinions as to how long the slowdown will last. Butmeanwhile, on inflation, our clients seem to be much longer onquestions than answers. Where does the current inflation spike comefrom? How long is it going to last? And can inflation abate without a"Paul Volcker" like monetary policy from the Fed?
In this ad hoc comment, we aim to review some of these questionsand, as we always tend to do--answer these questions with yet morequestions of our own! 
But of course, the surge in commodity prices cannot be the soleexplanation for the recent surge in inflation numbers around the world.After all, an event like the spike in oil prices could also prove to behighly deflationary, since it takes money from the private sector andgives it to the public sector which will typically waste it (i.e.:Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah,etc...). For a commodity price spike to be inflationary, it needs to beaccompanied by excess money creation. If it is not, all that we witnessis a change in relative prices across the economy (i.e.: oil prices up,auto and house prices down). This is why Milton Friedman once said that"inflation is always and everywhere a monetary phenomenon" while,around the same time, Jacques Rueff made the observation that"inflation is subsidizing expenditures that give no returns with moneythat does not exist".
So given that we are now living through a surge in inflationaryprices, the questions we should ask ourselves is a) where the excessliquidity creation of recent years has come from? and b) whether excessliquidity continues to be pushed into the system, hereby guaranteeingfurther increases in inflation in the coming quarters and years? 
While the Fed did print money aggressively between 2002 and 2005 (M1annual growth was above +5% and sometimes close to +10%), in recentyears, the pace of monetary creation has by and large been tame. So the‘excess money' had to come from somewhere else.
Now as we never tire of pointing out, two sets of players can createmoney ex- nihilo in our system: central banks and commercial banks. Soif the excess liquidity creation has not been the central banks, thenthe explanation must lie with the commercial banks.
And sure enough, in recent years, banks have ridden the 'financialrevolution' as hard as they possibly could and we have witnessed anunprecedented expansion in credit (witness the growth in C&I loansat US banks, red line below):
And, as we now know, money creation off the banks' balance sheetswas also, until recently, going strong. Witness, for example, the rapidexpansion in corporate paper outstanding in the period between 2003 and2007 (red line below):
To return to our old favorite, Irving Fisher's equation of MV=PQ, itseems obvious to us that the current increase in P (prices) has more todo with the past few years' extremely buoyant V (velocity) thanexcessive M (money) growth. A possibility which immediately raises thequestion of whether velocity will remain as buoyant over the next twoyears as it did in the 2003-2007 period. 
This message of slowing private sector liquidity growth is alsoconfirmed when adding the loans at commercial banks with the issuanceof commercial paper (for a total private credit growth aggregate--blueline on following page). We have slumped from an annual growth rate of+13% in private credit one year ago to +2.8% today; a level not seensince 2003 (see chart).
So we are now in a situation where a) The Fed is not printing moneyand b) US financials are de-leveraging rapidly. Thus, if inflation is"always and everywhere a monetary phenomenon", one may conclude thatwhat we are now seeing in the inflation numbers is the echo of the2003-2007 credit boom, but that looking ahead, the inflation pictureshould start improving rather dramatically. But such a conclusion wouldmiss out on the other big contributor to global liquidity growth,namely the US current account deficit. 
Now today, the US current account deficit still stands at a ratherlarge 6% of GDP. However, the composition of this deficit has changeddramatically: two years ago, around two-thirds of the US deficit wentto non-oil producers and one third was for petroleum products. Today,that situation is inversed to the point where one could argue that,while the US is still reflating oil producing countries (which hardlyneed it), it is now deflating non-oil producing countries by around 2%of GDP. Moreover, should oil prices start pulling back, we would moveextremely rapidly into a situation where the US current account deficitwas deflating the whole world (below is a chart we borrowed from The Economist)!
The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies.Indeed, over the past few years, the prevalent belief amongst investorsof all stripes has been: a) the US runs a large current accountdeficit, b) that US interest rates are low, and that, consequently c)the value of the US$ could only fall. And if the value of the US$ couldonly fall, then borrowing in US$ to finance whatever real estateproject, factory, or financial market speculation made perfect sense.This is why, in a number of countries, we started to witness a growthin central bank reserves which far outpaced trade surpluses and foreigndirect investment inflows; all of a sudden, a number of large countriesstarted to save more than they earned!
But how can one save more than one earns? The answer, we have argued in the past (see 
So what happens when a Chinese property developer, or a Vietnameseindustrialist, borrows US$ to finance his latest project? The firstthing he does is that he changes the dollars he does not need for RMB,Rupee, Dong, etc... And, at this point, the foreign central bank hasthree choices:
1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.
2- It can print money to prevent its currency from rising and then sterilize its FX intervention.
3- It can print money to prevent its currency from rising and justaccept the consequences of fast money supply growth (usually higherinflation and asset prices).
And by and large, this is what most nations on the other side of theUS current account deficit (i.e.: Asia and OPEC) have done. Andunsurprisingly, these are the countries that are today dealing with thelargest inflation threats.
We would thus argue that the US current account deficit has been a double inflationary force for the world at large.First, the US current account deficit has pushed a number of countriestowards reflation, and secondly, the large US current account deficithas helped propagate the belief that the US$ could only fall, and thusencouraged large borrowings of US$ outside of the US.
And the US current account deficit, combined with the willingness toborrow US$, has been an inflationary force for more than just Asia andthe Middle East. It may also explain the surge in money growth inEurope! Indeed, with central bank reserves growing very rapidly aroundthe world (despite a high oil price which, at the very least, shouldhave drained the reserves of Asian and European countries), centralbanks such as the PBoC or the RBI have likely spent the past few yearsdiversifying their reserves, which for all intents and purposes meansbuying the Euro... And, as we argued in our book The End is Not Nigh,this "diversification" of reserves means buying European governmentbonds or, in other words, subsidizing the expenditures of foreigngovernments with domestically borrowed money.
Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!" 
As does the weakness in US housing:
Meanwhile, the prevalent belief of recent years that borrowing US$to invest in local currencies was a "no-brainer" is now undergoing asignificant test. For example, in recent months, the "long dong"strategy has undeniably failed (the black market now expects adevaluation of over 20% in the Vietnamese currency). The strategy isalso failing in India where the Rupee, to many investors' surprise, hasbeen amazingly weak in recent months....
In fact, an interesting development is occurring on the US$: fewerand fewer currencies have lately been rising against the US$ and thisdespite some pretty poor news from the US (MBIA downgrade, fears onLehman, weak housing, weak growth, high oil, fears of war withIran...). Now the typical pattern for an equity bull market is that, asit nears its peak, fewer and fewer shares make new highs even asindices keep on powering ahead. Major corrections are typicallypreceded by a narrowing breadth... And today, we are undeniablywitnessing a deteriorating breath in the "anti-US$" bull market:
To cut a long story short, and with hindsight, the large US currentaccount deficit and the weak US$ were another very potent inflationaryforce in our system. But, at least at the margin, these inflationaryforces should abate, rather than acceler- ate, over the coming months. 
While the markets had started to rally in April and early May, thespike in oil prices fuelled fears of faster inflation and triggered athreat of coming rate hikes from the Fed and the ECB. In turn, allthese events weighed down equity markets around the world. However, aswe have tried to show in this paper: