Two Cases Against Inflation

Today's two anti-inflation perspectives come from the creme of the crop of establishmentarianism, and two of those who had no inkling the biggest financial crisis in history was about to hit until long after it did, one of whom was responsible for creating it, and the other, responsible for using up taxpayer funds to stay in business: Moody's and Morgan Stanley. Despite the firms' track records, the thoughts presented merit presentation in this most critical of debates.

First we present Moody's case, which claims that a return to the "disco" inflation of the 1970's is not happening, primarily due to the record amount of excess slack in the economy. Additionally, while not pointed out, the ongoing collapse in average wages does not bode too well for inflationists:

Expectations of much faster price inflation are slow to disappear despite the recent deceleration of core CPI inflation, limp income expectations, and the distinct possibility of another bout of home price deflation. Moreover, March’s surveys of manufacturers by the five District Fed Banks failed to uncover a meaningful increase in pricing power. We believe that those expecting a return of the “disco” inflation of the 1970s will be proven wrong if only because major upturns by inflation tend to be broadly distributed. Remember inflation’s short-lived energy led spurt of 2008 that looked pathetic compared to unprecedented home price deflation.

Of course, the one aspect that Moody's does not discuss at all is the surge in money printing. Yet as monetary aggregates are still falling, and all the excess money is held by banks in the form of excess reserves, the debate continues to be just what catalyst will force banks to part ways with this handy $1.2 trillion buffer. This is a major question especially since discount window borrowings have dropped to almost non-existant levels, plunging to just under $7.7 billion for the week ended March 31. This is the lowest amount since April 2008. Instead, here is what Moody's does focus on:

The US’ last two previous outbreaks of severe inflation were (i) the 3-years-ended January 1982 (core inflation averaged 10.9% annually) and (ii) the year-ended June 1975 (the annual rate of core CPI inflation averaged 10.6%). Comparatively high rates of resource utilization, and rapid rates of growth for payrolls, expenditures and employment income preceded those memorable episodes of severe price inflation.

The averages during the 24 months prior to the onset of severe inflation were: (i) 481K new jobs per month (adjusted for the subsequent growth of payrolls), (ii) 5.5% annualized growth for real GDP, and (iii) 12.3% annualized growth for employment income.

In contrast, the averages of the latest available 24-month spans showed (i) a loss of 349K jobs per month, (ii) a 0.9% annualized contraction by real GDP, and (iii) a 1.9% annualized contraction by employment income.

Prior to inflation's earlier surges, the averages were 5.5% for the unemployment rate and a -0.9 of a percentage point for the jobless rate’s year-to-year change. By contrast, February 2010’s 9.7% unemployment rate was up by 1.5 points from a year earlier. Moreover, the average hourly wage advanced by 7.0% annually on average prior to the previous inflation surges — compared to October 2010’s 2.5% yearly rise.

The last items of relevance, capacity utilization which is now almost 20% below where it was during prior inflationary episodes, as well as the barely noticeable increase in debt by the US nonfinancial sector. The latter is hallmark of this recession, as ever-increasing amounts of private debt are shifted to the US balance sheet.

Finally, February 2010's industrial capacity utilization rate of 72.7% revealed an excessive under-utilization of productive resources compared to both 1978’s 85.0% and 1973’s 88.3%. Q4-09’s 3.4% year-to-year increase by total US nonfinancial sector debt hardly compares to its annual charges of 10.8% for Q4-73 and of 13.6% for Q4-78. The latest upturn by nonfinancial sector debt remains tame notwithstanding an accompanying 22.7% surge in federal debt mostly because of a record deep -1.7% yearly decline by private nonfinancial-sector debt. State & local government debt outstanding grew by 4.8% annually in Q4-09.

A more comprehensive outlook on the general supply/demand mechanics comes from Morgan Stanley:

We have argued for some time now that there are substantial upside risks to the medium-term inflation trajectory globally. One of the main reasons - but not the only one - is the dire fiscal outlook in developed economies. We think that central banks may generate, allow or acquiesce to higher inflation in order to help overlevered public - but also private - sectors with their debt burdens: debtflation. A rational, forward-looking central bank may decide to generate or live with a controlled amount of higher inflation now, rather than find itself in a more difficult position a few years down the line because of unsustainable debt evolutions.

The obvious metric is of course the total amount of public debt - the higher, the bigger the incentive to inflate. This is borne out by ample historical and statistical evidence on the link between sovereign fiscal positions and inflation. But there are further factors which determine the incentive to inflate: the average duration/maturity of the debt; the currency denomination of the debt; the share of domestic versus foreign ownership; and the proportion of inflation-proof debt in the total amount of outstanding debt. This is how each of these factors affects the incentive to inflate:


  • Public debt overhang: The higher the outstanding amount of government debt, the greater the burden ofservicing it. Hence, the temptation to inflate increases with the debt.
  • Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce  the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate.
  • Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency.
  • Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt.
  • Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate.
To these purely fiscal arguments we add another dimension, private sector indebtedness:
  • Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate.

A little discussed issue, which Zero Hedge has long pointed out as very critical in various government's desire to reflate is the average maturity of existing sovereign debt: the lower the maturity, and the US is the undisputed leader in short debt duration, the greater the risk on overall rates should inflation take hold. And despite posturing by the US Treasury that it is willing to push out average maturities, the bulk of recent issuance has been in the Bill and CMB sector, even whan accounting for rolls:

There is also little to separate the countries in our sample with respect to currency denomination. All have debt that is almost in its entirety denominated in their own currency. In terms of the average maturity of the debt, the UK is a clear outlier at 13.5 years - suggesting a significant temptation to inflate.

In the US, on the other hand, the outstanding maturity is the lowest in our sample. However, average maturity of Treasury debt is set to rise quickly to post-war average levels on our US team's forecasts - and possibly beyond, if the historically strong positive correlation between the debt ratio and average maturity is anything to go by.

With regards to foreign ownership of debt, the euro area sovereigns have a very high degree of foreign ownership. However, because of cross-euro area holdings, what matters in this context is the share of debt held outside the euro area rather than outside an individual euro area country. Even though we have no hard data to back this up, anecdotal evidence suggests that most of the government debt is held within the euro area - due to the high degree of financial market integration. This would moderate any temptation to inflate, since euro area sovereign debt is mostly held within the euro area. Leaving the euro area aside, the US has the highest proportion of foreign-owned debt (nearly 50%) - a reflection of the dollar's global reserve currency status - and Japan the lowest (around 7%), with the UK somewhere in the middle (28%). Bearing in mind the caveat about the euro area, the US certainly stands out along this dimension of inflation temptation.

MS classifies the key countries with a massive debt overhang in terms of their overall desire to reflate.

From our bird's eye view of the numbers, Japan probably has the worst balance sheet, followed by the UK and the US - assuming that what matters for the euro-zone is the average and not its weakest link(s). On the other hand, Japan's public debt is mostly held domestically and its debt maturity is relatively short. These factors moderate the temptation to inflate arising from high public and private indebtedness. Indeed, the fact that the Japanese economy as a whole is a net foreign creditor to the tune of 50% of its GDP is another indication that much of the leverage of individual sectors is debt held by other domestic sectors - public debt for example being held by households and financial institutions. This means that the temptation to inflate is ultimately very low, despite high leverage.

The euro-zone seems to occupy the middle ground in our inverse beauty contest on just about all metrics. Risks to (price) stability for the euro area arise to the extent that the average masks some vulnerable economies. For example, there have been calls recently for the ECB to generate higher inflation because this would help the struggling periphery: expansionary policy would stimulate demand, and regaining competitiveness for the peripherals would require fewer outright nominal wage cuts. The incentive to inflate for the ECB would, in our view, arise to the extent that it perceives higher inflation to be conducive to rebalancing the euro-zone; this would make a hypothetical break-up less likely, thereby preserving the status - or even the very existence - of the Frankfurt institution. We attach a very low probability to this scenario, however, not least because the institutional set-up of the ECB ensures that no particular (group of) countries' interests prevail.

How about the US and the UK? We've already noted that both public and private sectors are highly levered. In the US, foreign ownership of public debt is very high, and the share of inflation-proof debt is relatively low (though higher than any of the euro area countries in our sample) - factors favourable to inflation. Debt maturity is short by international standards, but rising quickly towards the US historical average - and possibly beyond, if the historical correlation between debt and maturity is anything to go by. In the UK, debt maturity is very long but the share of inflation-proof debt is elevated. However, the UK has had a much worse inflation performance historically: average and peak inflation rates have been substantially higher than in the US. Overall, while the temptation to inflate in the two countries is higher than in the euro-zone or Japan, it is difficult to distinguish between the two.

Morgan Stanley's conclusion: Central Banks are likely not incentivized to generate blow out inflation currently, and if they did, it would take at least 2-3 years before the proper mechanisms are in place for this to take place.

Of course, our list of factors is far from exhaustive. In particular, it does not capture the ‘soft' aspects of the problem. Reputation is clearly a factor in this context. A reputation for stability - in the central bank context this means achieving low inflation on a sustained basis - takes a long time to build but very little to lose. This speaks against inflation as a course of action for central banks.

How about timing - when are we likely to see inflation if the risks were to materialise? Clearly, variations in the pace of cyclical recovery imply a different near-term inflation outlook for different economies. Our US team expects the inflation outlook to start turning towards the middle of the year; in the euro area, inflation will likely remain subdued for a while longer, given the tepid recovery; and Japan will likely remain mired in deflation for some time. Hence, inflation is unlikely to become a near-term worry. Returning to our debtflation framework, incentives also suggest that it is too early for the authorities to generate inflation. Some clients have pushed back - and we agree - that, for practical purposes, the duration of debt is shorter than meets the eye because large current deficits mean large immediate financing needs. From a strict ‘rational debtflation' point of view, the optimal timing for inflation would be when the bulk of borrowing is behind us (and maturities are longer in the US). On our forecasts, deficits will be slow to come down (see Global Forecast Snapshots: What Fiscal Tightening? March 10, 2010). Hence, inflation may still be a good 2-3 years off. But if we are right about output gaps being smaller than commonly appreciated, or if strong EM economies put pressure on commodity prices, then inflation may appear sooner than many think.

Regardless of whether MS' observations are right or wrong, one thing that is certain is that US debt, both private and especially public, is increasing. Furthermore, the asset coverage of such debt is getting increasingly tenuous, yet with baby boomers increasingly reluctant to park their money in equities, which seem to be traded exclusively by the pig farmers in recent days, this kind of forced capital reallocation into rates will simply make the inevitable rise in rates all the more painful for everyone involved. Lastly, the biggest wildcard, the record amount of money in the economy is still an undetermined factor. As the US has escaped from all empirical observations and has an unprecedented amount of excess reserves, the truth is that no economist has any idea just how this big variable will impact monetary policy at the point when the economy starts improving in earnest, and not through seasonally adjusted data subject to wildly incorrect birth-death adjustments. Which is why an ever increasing number of funds continue accenting the barbell trade: purchases of hard still cheap money-substitute commodities for that moment when inflation does run away from the Fed and the CBs, coupled with acquisitions of financials, which will be the companies that benefit the most from debt inflation. The rest of the capital is still invested in Treasury securities as a deflationary investment. However, with the 10 Year about to breach 4.0%, it may just be the case that the downside leg in the inflation/deflation trade will shortly be stopped out.




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