The common denominator linking China, the United States, Japan and European countries is they will all grapple with inflation, and hedging is no simple task
At last week’s Jackson Hole gathering, Ben Bernanke defended his case for further monetary stimulus to help the economy. It appears that QE3 is coming soon, possibly this month. I always believed that QE3 would come this year. The reasoning was based on how the Fed would react according to its dual mandate of price stability and employment maximization.
Short-term inflation data drives the Fed’s inflation concerns. As a weakening global economy has recently driven down commodity prices such as oil, steel, etc., and the weak demand forces suppliers to discount, the current inflation picture looks benign. Even though these factors are short-term in nature, the Fed has at least an excuse to ignore the inflation risk. While there is usually an 18-month lag between monetary policy and its inflationary consequence, most central banks tend to emphasize current rather than future inflation. The justification is that a central bank like the Fed is smart enough to take back the excess money supply before inflation hits, though there is little evidence that this is true.
Bernanke calls the U.S. economy far from satisfactory. This is the right characterization. The current unemployment rate is 8.3 percent. This figure understates the difficulties in the labor market. The current ratio of employment to population over 16 is 58.4 percent compared to 62.9 percent five years ago. The current total employment is 4.2 million less than five years ago. Considering that the labor force normally grows by over 1 million per annum, there must be a lot of discouraged workers who have stopped looking for jobs and are not counted as unemployed anymore.
Monetary stimulus works through decreasing borrowing cost or devaluing currency. The former works if there are borrowers who respond to lowering the interest rate. The U.S. household sector suffers high indebtedness. Its debt appetite is low. The U.S. corporate sector is sitting on a record cash level and isn’t likely to borrow and invest just because the interest rate is a little lower. The U.S. government suffers a high fiscal deficit and cannot increase it due to political deadlock. The dollar is strong due to the euro debt crisis and growth recession in emerging economies. QE3 may cheapen the dollar a bit, but won’t be enough to make a significant difference because Europe is in recession and the growth rates in emerging economies are being halved.
QE3 will merely exaggerate bubbles that have emerged in some areas. The S&P 500 is close to an all-time high despite a weak U.S. and global economy. Internet stocks, for example, have valuations in the stratosphere. Manhattan flats are surging in price again. If QE3 makes a difference, it is through making bubbles. While there may be some gain in the short term, it will lead to bigger problems down the road.
ECB Will Buy More Bonds
Mario Draghi, the president of the European Central Bank (ECB), promised to do whatever it takes to preserve the euro. His statement turned around sentiment in the Italian and Spanish bond markets. There is little doubt that the ECB has to support these markets to hold the euro zone together. And Draghi’s commitment works only if it is open-ended, i.e., it is willing to buy an unlimited amount to cap the bond yields for Spain and Italy. The ECB purchases are likely to be in the trillions of euros. As the ECB purchases such bonds from investors, a portion of the money would be diverted out of the euro zone. The resulting euro weakness will be the immediate transmission mechanism for inflation to hit the euro zone. Of course, the net increase in global money supply will inflate goods and services that have low price elasticity. Food and oil are good examples.
The ECB bond purchases, if big enough, can hold the euro zone together. It works through inflation to lower the real cost of social welfare in the crisis countries, like Italy and Spain. Cutting nominal expenditures has proven too hard to do. The main point is that ECB intervention works only if it creates inflation. While the ECB mandate is price stability only, the Draghi promise has put holding the euro zone together ahead of price stability. This is probably the path for the euro zone in the coming years.
Japan May Surprise
Japan remains in a vicious spiral of a strong yen and deflation. The Japanese economy hasn’t completely blown up because the government deficit is limiting the contraction of nominal GDP. The current government has passed a law to double the consumption tax to 10 percent by 2015. This will lead to acceleration of nominal GDP contraction. The consequences for the banking system are severe, as contracting nominal income pushes some debtors into bankruptcy. Also, like in the euro zone today, government revenue will contract due to austerity measures. Its desired target of deficit reduction may not be met.
Deficit control and deflation are not a viable combination. Japan has to end deflation for deficit reduction to be possible. The Bank of Japan will be forced into drastic actions to end deflation. It requires either open-ended commitment to keeping the yen low through intervention in the forex market or unlimited purchases of Japanese government bonds to target nominal GDP. The later would lead to yen devaluation, which forces other central banks to loosen monetary policy. The world as a whole will have more inflation.
China Remains Inflationary
Like in other economies, China’s inflation has slowed. The factors behind the trend, e.g., overcapacity, high inventory and falling commodity prices, are all temporary. The fundamental factors like money supply and labor market remain inflationary. The People’s Bank of China reported that broad money rose by 13.9 percent in July, far above the potential economic growth rate.
The tight balance in China’s labor market will drive the transmission from money to inflation. While the size of the cohort entering the labor market is slightly bigger than the one retiring, the portion available for manual labor is shrinking. College enrollment has expanded dramatically to about one-third of the age group from about 1 percent three decades ago. College graduates are unwilling to join the blue collar labor force. This has resulted in blue collar wages becoming higher than wages for college graduates. This change is critical to the inflation tendency of the economy, as China’s growth model is still dependent on manual labor.
While China is not embracing stimulus like in 2008, which is a good thing, the current spending pattern remains inflationary. Most money in the economy is spent by government agencies and state-owned enterprises. Neither pays attention to efficiency. When the temporary factors that hold inflation down are absorbed, the fundamental factors in the labor market and expenditure efficiency will reassert and turn today’s excess money supply into tomorrow’s inflation
The Inflation-Money Lag
When the economy is weak, most people have difficulties seeing inflation coming. The 1970s taught us that loose monetary policy could lead to high inflation in a weak economy. Inflation expectation alone can turn money supply into inflation. It takes time for the expectation to take hold. However, loose monetary policy has an immediate impact on the prices of traded commodities, which would feed into inflation quickly. When people see inflation despite a weak economy, they will adjust their expectations. The expectation eventually becomes the main inflation driver.
Globalization and financial crisis have increased the lag between inflation and money supply. The former makes supply global while demand remains local. Unless the exchange rate moves big, inflationary pressure can be suppressed by rising imports. When all countries loosen monetary policies, competitive devaluation occurs. Hence, the risk of big devaluation from loose money is reduced. Inflation is cooked in the whole global economy. In a larger economy, the lag between inflation and money is longer.
Financial crises cripple the balance sheets of some economic players. Money turns into inflation when economic entities borrow and spend. When economic entities are not in a condition to borrow, the transmission from money to inflation slows. The debt crises in developed economies since 2007 have exposed the precarious financial conditions of their governments and households. They are not in a condition to take advantage of low interest rates.
While the lag between money and inflation is longer this time, it is occurring where supplies are limited. Food products, for example, can respond quickly. The prices of soybean and corn have surged this year. The trigger is the drought in the United States. However, loose monetary policy has amplified the price reaction. Oil is another example. Despite contracting demand, oil prices remain elevated. Brent crude trades around US$ 115 per barrel, 5.5 times the average in the 1990s. High food and energy prices hit low-income people hardest.
The increased lag between money and inflation creates opportunities for speculation. Even though the global economy is in a poor shape, excitement could occur in some pockets. Prices in these pockets can skyrocket, as these pockets are small relative to the overall global money supply. In the past five years, we have seen many such bubbles come and go. Chateau Lafite, Chinese antiques, postmodern paintings, and puer tea are just a few examples. Many such bubbles are still standing.
As mentioned before, the prices of Manhattan properties are surging again. The financial crisis hurt the middle class most. The rich could still respond to low interest rates. Hence, the properties where the rich congregate appreciate with QE, while middle class properties sink in response to weak employment.
Despite a bad global economy, there is a big bubble in the stock market, not across the board, but in stocks with strong growth. Internet stocks have valuation similar to that during the last bubble in 1999-2000. Global consumer companies with mega capitalization value are trading at historically high valuation.
The biggest bubble is in government bonds. The interest rates on U.S. treasuries, for example, are half of the average inflation rate of the past five decades. German and Japanese bonds are in the same camp. Government bonds have total nominal value over US$ 50 trillion. When inflation expectation finally takes hold, the crash of this market may create another financial crisis.
One must consider the base effect and supply-demand balance for inflation hedging. I often receive questions on why property prices shouldn’t continue to rise with inflation. The difference is in the past. When the price of a certain commodity or asset has risen multiple times, it will decline even when inflation comes.
Let’s say that inflation in the future would double the general price level in a decade. Any commodity or asset that has seen its price more than doubled already may not be a good inflation hedge. The bubble phenomenon has made many commodities and assets bad inflation hedges.
Supply expansion decreases the attractiveness of an asset for inflation hedging. High prices due to bubbles have increased supplies in many assets and commodities. Their prices could underperform general inflation. I want to give China’s property and iron ore sectors as examples.
The land price in China has appreciated probably 30 times in the past decade, 100 times in some hot spots. Even though the general price level is likely to more than double in a decade, the price of land still has a long way to fall just to be in line with the overall price level. Further, the supply has expanded so much relative to population that its price relative to wages should fall too. Even though inflation is coming, Chinese property isn’t a good inflation hedge.
The price of iron ore peaked at about eight times the average price in the 1990s. The current price is five times. While the price performance is similar to oil, its fundamentals are much worse. The looming supply increase is 7.5 million tons per annum, more than China’s total imports. China’s steel consumption is declining. The total demand is likely to be stagnant in the decade to come, as the country’s property and infrastructure investments have peaked. The supply increase will make iron ore the worst performer in the commodity space. I suspect that the price of ore will decline by 50 percent from the current level.
Oil performs better than iron ore because its supply isn’t rising significantly. Unlike steel, oil can’t be recycled. Hence, its supply and demand balance is more favorable to its price. In the commodity space, the stocks of oil companies could be good inflation hedges.
Because most assets good for inflation hedging are already inflated, one may have to adopt a dynamic hedging strategy. Inflation is a process. Paper money erodes gradually in value. Holding onto cash is still good for now. When inflation is recognized, government bonds will drop in price to reflect inflation in future, one can switch cash into bonds then. This strategy is probably the best for most people. Waiting will bring a payoff.
Source: Caixin Online
Category: Think Tank
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