First part of inflation cover

In: Uncategorized

18 Oct 2011

This is the first part of my inflation cover story for Fund Strategy. I will paste the second part tomorrow.

The often acrimonious debate about the risks of runaway inflation is split into two hostile camps. On one side, the hawks argue that the huge monetary stimulus underway in western economies will sooner or later fuel high inflation. On the other, the doves contend that the prospect of a new global recession is a more pressing concern.

The stakes are high. If the hawks are right, the monetary taps have to be turned off, or at least the flow of money reduced, as soon as possible. Otherwise the world could be ravaged by high inflation, as it was in the 1970s. Such a prospect is alarming for bond fund managers. Runaway inflation is to bonds what a burning match is to a dry forest. Rapidly rising prices have an incendiary effect on the value of fixed income investments.

If the doves are right, the monetary taps need to run even faster. If more stimulus is not added the world risks descending into something akin to the Great Depression of the 1930s. Without additional stimulus the level of global demand could plummet.

The choices as they are presented could not be starker: more stimulus, or less; a descent into a global recession akin to the 1930s, or runaway price rises reminiscent of the 1970s; Great Depression, or hyperinflation.

Unfortunately, the dispute cannot be resolved by referring to the facts alone. If it were that simple there would be little need for debate. There is enough evidence for both sides to make a reasonable case.


Perhaps the strongest evidence that there is a risk of runaway inflation comes from Britain – an uncomfortable fact for anyone who lives in the country. Consumer prices index (CPI) inflation, at 4.5%, is the highest of the large developed economies. Retail prices index (RPI) inflation, which takes into account some housing costs, is 5.2%.

Considering that the Bank of England’s CPI inflation target is 2%, these figures look particularly bad. If the target is missed by more than one percentage point either side during a quarter the governor has to write an open letter to the chancellor. Mervyn King has written 11 such explanatory letters since June 2008. Typically he has put the blame on one-off factors such as the depreciation of sterling, rising commodity prices and an increase in VAT.

Although headline inflation in America is lower than Britain there is still a strong case for latent inflationary pressures. The Federal Reserve has expanded its balance sheet more than three-fold since the risk of a financial crisis began to become apparent in mid-2007. The Fed’s balance sheet reached $2.8 trillion (£1.8 trillion) at the end of September 2011, compared with $869 billion on August 8, 2007.

Globally, too, there are signs of inflationary pressures. According to figures from the International Monetary Fund (IMF) both commodity prices in general and food prices have almost doubled since 2005. Consumer inflation is particularly high in emerging and developing economies with an average rate of 7.5%.

If Britain provides the best case for the prosecution, in relation to the risk of runaway inflation, Japan illustrates the model defence. CPI inflation is only 0.2% in Japan despite a huge monetary stimulus over many years. Quantitative easing (QE) was a reality in Japan from 2001-06, while unknown in America and Europe outside academic economists.

Japan also pursued what became known as Zirp over the same period – zero interest rate policy. Although the term has not caught on in America or Britain it is what both countries have pursued. Under Zirp, credit from the central bank becomes so cheap that its cost is almost zero. Yet neither of the Anglo-Saxon economies has yet suffered rampant price rises.

If there are few signs of rising inflation in America so far, the bond markets indicate that it is not expected soon either. If inflation was on a rising trend the cost of long-term credit, reflected in bond yields, would be expected to increase too. Yet yields on 10-year Treasuries were only about 2% at the time of writing.

The expectations of the bond market are roughly in line with those of experts. According to the latest quarterly survey of professional forecasters by the Federal Reserve Bank of Philadelphia, the headline CPI inflation rate is expected to average 2.4% a year to 2020.


If the numbers alone are insufficient to make a decisive case either way it is necessary to dig deeper. Probably the best starting point is to look more closely at definitions. For even at this level it soon becomes clear that some of the arguments about inflation are at cross-purposes.

The most straightforward definition of inflation is that it is the rate of change of prices. If a selected basket of goods cost $100 one year and $105 the next then, by this measure, the inflation rate is 5%.

Such a measurement is simple in theory but difficult in practice. Statisticians spend a lot of time working out what baskets of goods are representative of spending more generally. Then there are several different measures of inflation to choose from, including the ­­CPI, RPI and producer price indices (PPI).

But many influential economists do not accept that changing prices alone represent inflation. Some insist that inflation should be defined as a sustained rate of increase in a broad-based price index. By this definition short-term factors, such as volatility in energy and food prices, should be stripped out.

This understanding of inflation explains why many American economists prefer to focus on the core measure of inflation – stripping out food and energy – than the headline rate. For its advocates the former measure is a better indicator of the long-term trend. Both approaches have advantages and disadvantages. According to the latest edition of the twice-yearly World Economic Outlook from the IMF: “In practice, food and energy prices are less indicative of medium-term inflation pressures than are the price changes of other goods and services. That said, using this simple ’exclusion’ measure as an indicator for underlying inflation raises some problems. Because it places zero weight on food and fuel prices, core inflation can be a poor measure of the cost of living. In addition, some argue that food and energy price inflation does contain useful information about underlying inflation and, therefore, hints at the likely evolution of inflation pressure over the medium term.”

Some economists go radically further than the debate between advocates of core and headline inflation measures. For some economists associated with the free market school the term “inflation” does not refer to change in prices. Instead it is about the amount of money circulating in the economy. So for Ludwig von Mises (1881-1973), writing in 1951, inflation referred to “increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check”. For him rising prices were a consequence of the inflation of the money supply.

Through examining these definitions it is at least possible to get a better handle on the debate. When experts claim that inflation is changing at a particular rate it is necessary to be clear what definition they are talking about. It is quite possible for inflation to be rising rapidly by one definition and rising less rapidly, or even falling, by another. For example, if energy prices were stripped out of Britain’s CPI measure of inflation the rate would be significantly lower.


Before digging deeper into explanations for the causes of inflation it is necessary to reject some common misconceptions. It is all too common for superficial arguments about inflation to be accepted at face value.

Take the claim that rising energy prices are driving inflation. It is certainly true that rapid increases in energy prices are associated with an increase in the CPI. For instance, if oil prices quadrupled in a short period then the CPI index would be expected to surge as energy is a significant proportion of the overall basket.

Those familiar with statistics will notice that such claims relate to correlation rather than causation. In this example rising energy prices do not, strictly speaking, explain higher inflation. That is a tautology: in effect it is saying that rising prices cause rising prices. It is simply that the way the index is constructed means that a certain rise in energy is associated with a particular increase in the overall index.

To give a true explanation it is necessary to go at least one step further. It must be shown why the price of energy itself is rising fast. This can only be understood by examining the interaction of supply and demand in this particular case. It cannot simply be assumed as if it were a natural phenomenon. Nor it is sufficient, as many commentators do, to simply look at the demand side of the equation. History shows that prices can fall in the face of rising demand as long as supply is increasing faster.