Wednesday, 25 March 2009

Ten reasons why inflation will accelerate

First, a confession. I didn't expect inflation to pick up in February. I anticipated a short-term dip in 2009 as the economy slowed. The inflationary surge would come next year due to the combined effects of a mammoth fiscal deficit, zero interest rates, and the Bank of England printing truckloads of cash.

As part of my recovery from the shock of yesterday's CPI data, I began to reconsider the case for a more accelerated move towards rapid inflation. The more I thought about it, the more yesterday's number made sense, and why it could be the precursor of some very unpleasant inflation numbers in the near future. Eventually, I came up with ten reasons why inflation could be coming to town sooner rather than later.

1. The underlying CPI sub indices are rising more rapidly than expected

February food price inflation was particularly disturbing. The annual rate was over 12 percent, while the monthly increase was a full 1.5 percent. That sharp rise was not due to seasonal factors. In February last year, the monthly increase was just 0.3 percent. Other sub indices, such as furniture, household equipment and maintenance, clothing and footwear, also point to persistent inflationary pressures.

2. Oil prices are rising again

The price of a barrel of crude is now $53. A few short weeks ago, it was hovering below $40. That represents roughly a 30 percent increase. Just as the collapse in oil prices led to a deceleration in inflation towards the end of last year, the recent surge in oil prices will push the rate back up again.

3. The gold price is also rising

Today, gold is trading at $925 an ounce. Only a few short months ago, it was bouncing around at about $700 an ounce. Since gold is the ultimate inflationary hedge, the sharp price increases tells me that inflation expectations across the world are swinging upwards. No doubt some of those gold investors are UK residents.

4. The sterling depreciation will keep inflation bubbling in the short run

According to Mervyn King, sterling has depreciated by 28 percent since the credit crunch started. As if this was somehow detached from the policy choices of the Bank of England, King acknowledged that this would pass through into inflation via elevated import prices. We may not have seen the full force of the devaluation in the CPI. This alone should guarantee a few more difficult months for the Bank of England.

5. Foreigners are selling UK assets, which could put further downward pressure on Sterling

External liabilities of UK banks are perhaps the most alarming numbers produced by the Bank of England. It shows that nonresidents are pulling their cash out of UK banks. This capital flight probably accounts for the recent dramatic fall in the value of sterling. If this capital flight continues, then sterling could come under additional pressure, pushing import prices up further.

If nonresidents panic, the UK could have an exchange-rate crisis. The consequences of such an event are too dreadful to contemplate. It is a scenario which I would prefer to leave in the dark recesses of my imagination.

6. The UK money supply is growing at almost 17 percent a year

This fact is perhaps the most difficult one for deflationists. UK monetary growth is accelerating. The standard deflationist response to this awkward number is that it doesn't matter because most of this new money is being held by banks hoarding liquidity.

In the short run, that may be true, but that doesn't make money held by banks any different from money held by households and corporations. When banks stop hoarding cash and release it into the economy, it will feed directly into higher prices.

7. UK policy rates are highly negative

The Bank of England's policy rate, adjusted for inflation is minus 2.8 percent. OK, I will admit that this is not my strongest argument, not least because the bank rate is now irrelevant in terms of managing overall liquidity conditions. However, it still has powerful symbolic value, expressing the policy confusion that has gripped the MPC.

8. Fiscal policy is out of control

In terms of fiscal policy, New Labour has lost the plot. The UK government is about to run out the largest deficits since the Second World War. These deficits will be larger than anything produced by those ancient lords of inflation - Heath, Wilson, and Callaghan.

9. The Bank of England will monetize the fiscal deficit

All hyperinflations are due to one thing; central banks printing money to cover government deficits. While I'm not suggesting that the UK is in imminent danger of turning into Zimbabwe, the fact remains that monetizing the fiscal deficit is always and everywhere highly inflationary.

10. UK policymakers have lost control

The Bank of England and the Treasury are no longer in control of events. New Labour is paralyzed with fear, knowing that a painful fiscal adjustment before an election will destroy the party. Darling knows that he needs to cut the deficit, but it is politically impossible.

The Bank of England is also powerless. The MPC cut the bank rate too far. It is now disconnected from real economy. The MPC can no longer control liquidity conditions, a fact implicitly recognized in a recent speech by MPC member - Kate Barker. Under normal circumstances, yesterday's CPI data would have required a robust hike in rates. However, the MPC know that it would need to raise the bank rate by several hundred basis points in order to regain some policy traction. In the current political environment, such a move is inconceivable.

So what is the argument against higher inflation? The economy is slowing and therefore firms will be reluctant to push up prices. This may come as a shock to some people, but rapidly rising inflation is invariably associated with weak economic growth. A quick look at the UK growth numbers during the 1970s will confirm this fact.

The UK economy is certainly slowing, and in the short run this might put some modest and temporary downward pressure on prices. However, the prevailing reality is that the UK macroeconomic framework is a total mess. It is incoherent, irresponsible, and driven by short-term political expediency. Sooner or later, this toxic cocktail of confusion will feed into higher prices.

20 comments:

Josh said...

Hyperinflation is definitely on the way.

dearieme said...

Need it be hyperinflation? Would a few years of 10%-30% per annumm do the trick? N.B. I take it for granted that HMG will default on its debt and that inflation will be the chosen method of default. But I suspect that hyperinflation won't be chosen, that it would arise only by cock-up. Mind you, cock-up is what they are notable for.

John Pickworth said...

Agree.

I've been telling anyone who cared to listen - or who couldn't run away fast enough - that inflation was the sleeping dragon we should all be worried about.

The good news though, the American's will be able to say next year that global inflation started in the UK. Gordon should love the irony in that.

QG said...

Well let's look on the bright side. Those with huge mortgage debts who can hang for a bit longer should see their real debt whittled away. Keeping the house price debt binge going was one of the factors that lead to this mess. If you have savings, it may be worth thinking about converting some of them into assets soon.

If you have a minute and a half to spare, here's a little joke on a related subject, by Peter Schiff, about the prospects for the Chinese getting their money back from the Americans. Again, inflation will be the likely result.

(Just the first 1 and a half minutes) http://www.youtube.com/watch?v=2bLe9Sy4q8g

Caronte said...

All ten very good reasons. Let us worry a great deal, but not talk about hyper-inflation.
Hyper-inflation is defined as over 50 per cent PER MONTH. This is Zimbabwe alright, where it is close to 100 per cent PER DAY. But leave the doom terminology where it belongs, it does not belong to England. YET.

Elby the Beserk said...

Briefly then, Brown has succeeded in economic terms where Hitler failed? Is there not a case to have the man apprehended, held in the Tower and then executed in public on Newgate?

Anonymous said...

China and Japans massive fall in exports also means there will be too few items, in stock, in the shops for consumers to spend their money on. This will also fuel the inflation.

Anonymous said...

Interestingly Caronte, I heard on the world service that Zimbabwe had a very low inflation rate in January. They said it was because they had given up on their own currency and were using the USDollar. Would we be better with the Dollar or the Euro when we do the same?

electro-kevin said...

"Those with huge mortgage debts who can hang on a little longer ..." (20.40)

If your wages keep pace and interest rates remain low.

Anonymous said...

Brilliant stuff Alice!
Keep up the good work! That's the best analysis of the inflation scenario I have read today, and I have read a lot of them!
I love your site.
Housing Bear

fajensen said...

If your wages keep pace and interest rates remain low.

Hmf: I got a 4%, 30 year fixed rate mortgage. I want rates to RISE!

Adrian said...

I think the 17% increase in money supply is the most worry thing, because when this does hit the market, inflation will really take. Its all well and good the banks and governments inflating their way out of debt but for the rest of us with mass unemployment and wages decreasing, this will have an increased effect.

This is the biggest transfer of wealth in history - Gordon Brown is the modern day 'reverse' robin hood. Robbing from the poor to feed the rich.

Man in a Shed said...

I can vouch for reason 3.

Man in a Shed said...

Also "In the current political environment, such a move is inconceivable." - you suggest that interest rates are really politically controlled.

That's backed up by Gordon Brown's back tracking in New York trying to claim borrowing to insolvency is only one of three ways he plans to wreck the economy.

Missouri-man said...

Your blog "Ten reasons why inflation will accelerate" is not very persuasive.

Overall, you seem to think that governemnt policies to avoid deflation will actually work, and we risk higher inflation as a result. But how successful has the government been in the past, at solving financial problems?

You give them too much credit. On the one hand, you argue that "UK policymakers have lost control", while at the same time you argue that they will succeed with their present policies in returning us to an era of boundless borrowing and spending, and thus to an era of inflation.

If anyone really believes this, then they need to go out and buy shares and houses to protect themselves against the coming fall in the value of the currency - not many people are actually doing this, but that is what you appear to recommend.

To anyone reading this who thinks inflation is just around the corner: have the courage of your convictions and pile into the stock market and buy-to-let. I bet few will dare!

You don't really have "Ten reasons". You have a few basic points, some of which are repeated and others that are non-sequiturs.


To deal with them point by point:


1. The underlying CPI sub indices are rising more rapidly than expected.

The main component is food. For a nation that imports half its food, and given the fall in the value of sterling, it is not surprising that the CPI is relatively high.

But falls in sterling cannot go on for ever, so this cannot be a long-term cause of inflation. Even if the value of sterling were to collapse to half it's present value - to, say $0.75 - we would still only get a one-off push to inflation that would end pretty quickly.

Also, if imported food costs too much, most people will simply stop buying strawberries that have been air-frieghted in from the other side of the world. The CPI may be temporarilly high, but people simply adapt their buying to get around it.


2. Oil prices are rising again

True, but not by very much in historical terms. The oil price has been far above this level for the past 5 years. Given the world-wide recession, it is hard to imagine prices at the $100+ level any time soon.


3. The gold price is also rising

The gold price has see-sawed in the $700 - $1000 range for a couple of years and the latest rise is nothing special. The price of gold was rising strongly before that for 7 years or more - long before anyone was thinking about inflation.

Your argument is a non-sequitur: the recent rises do not imply higher inflation.


4. The sterling depreciation will keep inflation bubbling in the short run.

True, but see 1 above.


5. Foreigners are selling UK assets, which could put further downward pressure on Sterling

True, but this is just another version of your argument: "sterling is falling, so we'll get higher inflation".
See 1 above.


6. The UK money supply is growing at almost 17 percent a year

True, but this doesn't necessarilly lead to higher inflation. The money has to be borrowed and spent. For that you need both willing lenders and willing borrowers.

Willing lenders: the banks have trillions of liabilities still festering away, and all the bail-outs are doing is merely keeping their heads above water and preventing a total collapse, not solving their long-term problems. Banks won't become willing lenders for a very long time.

Willing borrowers: if you are scared of loosing your job, you will not go out and borrow money. The days of borrowing and spending like there's no tomorrow are long gone, and are unlikely to return for a generation.


7. UK policy rates are highly negative

So what? That just means inflation is temporarilly higher than interest rates. When we enter the period of deflation interest rates will turn positive. Money stuffed under the mattress will appreciate even with interest rates at zero.


8. Fiscal policy is out of control

I tend to agree, but your argument is a non-sequitur: it does not follow that inflation is the inevitable consequence.


9. The Bank of England will monetize the fiscal deficit

They may try, but as Mervyn King recently pointed out, there are strict limits beyond which they cannot go.


10. UK policymakers have lost control

True, but this is a re-hash of your earlier point 8.



Inflation is yesterday's problem - fear deflation!

VADO said...

Missouri man

Your point by point rebuttal was rather poor.

You appeared to concede most of the arguments anyway. For example, food inflation is rising because the exchange rate is falling, and the UK imports most of its food.

However, let me address one point. The exchange rate is the relative price of two currencies. If the relative supply of one currency rises, its price will fall.

The relative supply of sterling is increasing at 17% a year. This is why it is crashing, and yes it can go on forever. Hence food inflation is up.

Exchange rates don't have a bottom. It central-bank prints enough money, the inverse of the exchange rate can fall to zero, which is another way of describing hyperinflation.

Besides, the data is against you. UK inflation is rising not falling.

VADO

Stevie b. said...

Alice - I think a persuasive counter-argument is to be found here, in the comments by hbl:

http://www.creditwritedowns.com/2009/03/stephen-roach-is-still-bearish-no-recovery-until-2010.html#comments

Missouri-man said...

VADO:

1) The only thing I am conceding is that a fall in the value of sterling will give a small and temporary push to inflation.

2) You say: "If the relative supply of one currency rises, its price will fall.
The relative supply of sterling is increasing at 17% a year. This is why it is crashing,"

But the evidence is against you.

Over the period 2002 - 2007, the growth in the UK money supply increased from about 6% a year to about 14% a year.

Over the same period, sterling appreciated from about $1.43 to over $2.00, a rise of about 40%.

So, no evidence of a crash in Sterling due to increases in the money supply.


3) Alice (and you?) appear to argue that rises in the money supply are a strong cause inflation.
Again, the evidence is against you.

Over the period 2002 - 2007 when the money supply was rising strongly, the rate of inflation as measured by the CPI see-sawed in the range of 1% - 3% with a slight upward drift towards the end of this period. It is difficult to make the case that CPI is strongly affected by changes in the money supply.

4) Both you and Alice choose CPI as the measure of inflation, but CPI excludes housing costs, so it is not very realistic.
Housing costs are the largest item of expenditure for many households. These costs are included in the RPI, where it has by far the largest weighting, more than double that of food or anything else.

Real-life inflation, as measured by the RPI, has fallen to zero. So, no evidence of runaway inflation here.


5) Bottom line:

- Increases in the money supply have no effect on the value of sterling, and little or no effect on the real rate of inflation.
- Simple "Supply and demand" arguments do not adequately explain the value of sterling or inflation.
- We are not at the start of a massive and long-lasting upswing in inflation.

Trade To Win said...

Three interest rate announcements from the Reserve Bank of Australia, Bank of Japan, and Bank of England will take the center stage in the week ahead.

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