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Reading the inflation tea leaves

13 Aug 2021 2 month(s) ago

The most important question facing investors is what will happen with interest rates, which depends on what happens with inflation.

Most analysts think of economies as closed systems. So when monetary authorities print money with their ears pinned back, surely that inevitably means inflation. Right? Well, not exactly. Because, as we shall see, the system is not closed.

There are troubling indications, though. Not because of the money printing but because of supply chain problems.

There is a lot of disruption to shipping at China’s busiest ports, and even Vietnamese and Thai production is being impacted by the virus. As one report says: “Anecdotes are of shippers telling clients they will not deliver except at a premium; of smaller firms, and countries(!), being pushed down the priority list; of ships refusing to pick up goods exports from some locations; and of a structural supply-demand mismatch of sought-after shipping containers.”

Container ship costs are soaring, which will increase costs in global supply chains. Those costs will inevitably be passed on in higher prices:

What happens with inflation is crucial to the short term survival of the whole system. Global debt, which is running at well over 300 per cent of global GDP, is only sustainable because interest rates are exceptionally low (the base rate in Australia is only 0.1 per cent). And interest rates are low because inflation is not a problem.

The orthodoxy followed by central banks is that if inflation rises beyond a certain level, then interest rates must also rise to reduce the supply of money in the system. Central banks no longer have any control over the quantity of money, so the only lever available to them is the cost of money, or interest rates. As we will see, that orthodoxy is about as relevant to the modern financial world as the horse and cart is to Grand Prix racing, but it is nevertheless what economists are taught at university and so that is what they will do.

Should inflation, and then interest rates, rise a significant portion of the debt would become unserviceable, which would put the banks under pressure. So far, however, inflation, as measured in the Consumer Price Index (CPI), has stayed quiescent. There has been no reason to take the risky step of raising rates, which in Australia would imperil our outrageously indebted housing market. 

According to conventional economics, it should not be this way. Since the covid crisis, most central banks have been effectively printing money in a process called Quantitative Easing, whereby they buy back government debt, and sometimes corporate debt and put it on their balance sheets. With so much more money being created it should mean that inflation soars, but it is not. Why?

Two reasons suggest themselves. The first is that the extra money has not gone into spending on the things that are measured in the CPI such as: food, transport costs, clothes and rent. Instead, it has largely poured into assets such as housing and shares. 

Asset inflation is not something that central banks can measure or analyse easily. Unlike the things included in the CPI, which are constantly being bought and sold and are therefore easy to track, asset transactions are lumpy and irregular and the value is only realised when there is a trade. Consequently, central banks put asset inflation into the too hard basket and don’t let it affect their decisions on interest rates.

There are signs that asset inflation is beginning to leak into consumer price inflation, though. As analyst Bill Blain comments the “last 12 years of monetary experimentation, quantitative easing, and buying back bonds and keeping interest rates artificially low” has caused inflation in financial assets, which he believes “is now creeping into the real world.” If that happens and then interest rates rise, hold on to your hats.

The second reason that money printing has not resulted in consumer price inflation is that Western financial systems are not closed. The models economists tend to use implies a closed system. If you print too much money in a closed system and the amount of production stays the same then it follows inevitably that prices will rise. That is the orthodoxy.

But these systems are a long way from closed. In the US system, for example, $US6 trillion flows across borders every day. It is how America is getting away with currently spending twice what it is taking in as tax revenue. There are so many US dollars sloshing around the world that the American governments profligacy gets lost in the mayhem.

It is the same with the money printing and inflation. Because the money that is being created out of thin air is then moving all over the world in cross border transactions, it is not held inside the system and so does not cause consumer price inflation. 

But that could easily change. If there is one truism in financial markets it is that the future will be different from the past and there may be growing pressure for inflation in tangible assets like fertile land. This will in turn cause consumer prices to go up, starting with food.

At some point there will be a price that has to be paid for such recklessness.


Reader note: This is general reporting only and should not be considered in any way to be investment or tax advice. It does not take into consideration the investment objectives, financial situation or particular needs of any particular investor. For more information please read our disclosure statement.


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