Inflation Accommodation:
by Doug Noland
We operate in an extraordinarily uncertain environment. There is a great deal we simply don’t know, and we are at no disadvantage admitting this reality. I thought Pimco’s Bill Gross wrote an especially insightful piece this month (“Circus Game”). He makes the point that “Pimco made its fame and fortune partly on the basis of accurately forecasting those two primary secular trends” – a long wave of inflation from 1965-79 and a wave of disinflation from 1980 to 2000. Mr. Gross adds that, “The future may not be so simple.” It surely will be quite complex and analytically challenging.
Mr. Gross aptly uses a metaphor for the global economy of a circus high-wire performer, tenuously balancing to avoid tipping either toward inflation or deflation. An eventual slip could lead to a crash landing. This metaphor provides a good starting point for analysis and contemplation.
First of all, my sense is that the key issue today is not so much an epic battle between the forces of Inflation vs. Deflation. Rather, we are in the midst of an increasingly unwieldy (historic) global Credit Inflation – the struggle between the powerful forces of Global Credit Boom vs. Bust. The “balancing act” is between global central bankers and market dynamics, each jockeying with the processes of global financial excess, over-liquidity and boom and bust dynamics.
Over the past 18 months, U.S. Credit Bubble excess has gone global, with quite uncertain ramifications. Perhaps I would have a tight-rope performer rapidly peddling a bicycle instead of walking nervously. The wheels of global Credit creation are spinning rapidly. Two issues come immediately to mind: Is this Credit environment sustainable and is there a palatable end game?
The bottom line is that we have had very little pertinent experience with global Credit booms. Indeed, I would strongly argue that today’s analysts, economists and policymakers have only the shallowest understanding of Contemporary Credit Inflation. With a focus on the narrowest of inflation indicators – CPI – analysis remains oblivious to the most powerful inflationary forces. There is certainly little appreciation for the nature of Contemporary Inflationary Manifestations nurtured by domestic securities-based Credit and speculative excess. Moreover, there is absolutely no appreciation for the consequences of unleashing U.S. Credit Bubble dynamics globally.
I am fascinated with the notion of “disinflation.” Particularly in the U.S. during the nineties, financial evolution, “globalization,” and changes to the underlying structure of the economy altered the nature of inflationary manifestations. There were myriad powerful forces at work changing the financial and economic landscape, working to suppress goods price inflation while promoting asset price inflation. As I have written previously, inflation was not conquered but transformed. Importantly, the U.S. Credit system moved rapidly towards a marketable securities-based Credit system. Asset-based lending (securities and real estate) came to dominate, as aggressive institutions raced to harvest ultra-easy financial profits in an environment of generally declining and central bank-governed interest rates. It may have been a period of rather benign consumer price inflation, but our social, institutional, political, and regulatory biases fomented historic asset Bubbles.
In my view, it has always been a case of rampant U.S. Credit inflation impairing the dollar. What was not at all clear, however, was how the Federal Reserve, global central banks, our foreign creditors, investors, and speculators would respond when King Dollar eventually succumbed. We now have a much better idea. The Greenspan Fed is fully committed to sustaining U.S. Credit and financial excess (Inflation Accommodation). There will certainly be no domestic push to rein in mounting imbalances. Instead, the Fed is determined to impel foreign central bankers to adopt increasingly inflationary policies – hoping to balance ongoing U.S. inflation and imbalances with heavier global inflationary stimulus. Dollar purchases and global liquidity creation orchestrated by the Asian central banks over the past year have been unprecedented. And we know that, to this point, the resulting global environment (weak dollar & strong global liquidity) has global speculators and investors scampering to buy non-dollar securities and assets – as opposed to liquidating U.S. instruments.
Ballooning U.S. current account deficits and the newfound global financial melee have fostered some extraordinary economic and market effects. Clearly, the global “reflation trade” got completely out of hand. A mushrooming global leveraged speculating community crowded into trades long global equities, emerging market debt, high-yielding securities generally, and commodities. Over the past month or so, many of these trades have gone sour and been unwound. At what stage of liquidation we are at these days is unclear. But thus far the consequences of “de-leveraging” are not as dramatic as I would have expected. There has been and continues to be some tumult on the periphery, but signs of faltering systemic liquidity are at this point rather nebulous.
To say there are profound crosscurrents today does not do the current environment justice. Over the past 18 months global financial markets have been buffeted by unprecedented speculative leveraging and, more recently, de-leveraging. Conspicuous Bubble dynamics have been in force. But, at the same time, it is also clear that the global financial system is in the midst of some rather profound structural change.
I would contend that there has been a continuing push toward U.S.-style securities and derivatives-based Credit systems. With a couple key strokes on my Bloomberg, I can monitor India’s bond futures and swaps pricing, Chinese repo and swap rates, and financial futures prices for countries from Brazil, to Poland to Turkey to Taiwan. And while there is nothing particularly new about global financial innovation and evolution, my sense is that it does not garner the attention and analytical focus it deserves. Developments have been profound, and I would argue the ramifications could continue to include heightened Credit Availability and liquidity for markets and economies across the globe.
While I see Bubble dynamics in play and recognize the vulnerability of this highly-leveraged global financial daisy-chain, sound analysis requires that we contemplate various scenarios. On the one hand, a serious bout of global “de-leveraging,” faltering liquidity, dislocation and crisis could quickly impair these types of market-based Credit mechanisms. But, on the other hand, these systems could continue augmenting financial excess. Global central bankers are certainly keen to avoid the former and likely willing to risk the latter.
Repeatedly during the nineties, bouts of global financial tumult, and the resulting flight to the perceived safety of the dollar, brought many (especially “emerging”) Credit systems to their knees. Global financial “evolution” was often sidetracked. It is today worth pondering – with the demise of King Dollar – to what extent the global backdrop has changed. Is there today less propensity for destabilizing flight away from periphery markets to the “safe harbor” of dollar assets? Has the weakened dollar actually created more robust Credit systems for many economies throughout Asia and the periphery?
I am reminded of the difficult analysis from last summer and autumn. The mortgage finance industry had ballooned to enormous size. Interest rates were rising, and it appeared that the mortgage-refi gravy train was set for a rapid slowdown. The outlook for the booming U.S. housing market and household spending was in doubt. Well, the exact opposite of the slow-down scenario unfolded. The powerful mortgage lenders quickly adapted (helped immeasurable by an accommodative Fed), introducing and aggressively marketing products such as teaser adjustable-rate and interest-only mortgages. Home equity lending boomed. The Great Mortgage Finance Bubble did better than survive, and we are well on our way to another record year of mortgage Credit growth and home sales. This important episode reminds us to respect the immense power of booming contemporary Credit systems.
The global financial system has some very significant vulnerabilities; it also has some things working today in its favor. The Fed is at 1% and married to baby step gradualism. They will also likely signal to the markets an upper-bound on its rate intentions. The Japanese, despite a recovering economy, are understandably cautious and appear willing to err on the side of continued massive reflation. And it would appear today that the Chinese will as well err on the side of caution, accommodating strong growth but with more determined efforts to rein in excesses in key sectors. The global backdrop remains one of extreme central bank accommodation with extraordinarily low interest rates prevailing.
So, let’s attempt a return to the issue of the balancing act of Inflation vs. Deflation, or Global Credit Boom vs. Bust. As analysts, we have challenging work ahead of us. With massive U.S. current account deficits as far as the eye can see, coupled with continued central bank accommodation, there is a distinct possibility that global Credit systems could continue to surprise on the upside. If central bankers are successful in arresting global de-leveraging (a not insignificant “if”), then the global Credit system could very well follow a similar path to that of the U.S. mortgage system.
I would argue today that, despite generally rising market rates and not insignificant de-leveraging, along with notable financial stress, there are global inflationary biases unlike anything experienced in quite some time. The strongest inflationary manifestations are in housing and energy markets, and it is very much a global phenomenon. And for several years, we have witnessed how housing price inflation and Credit excess are self-reinforcing. Excess begets additional inflationary excess, with booming markets creating their own (over) liquidity. Now we will likely have the opportunity to study inflationary dynamics as they apply to energy markets and consumer prices more generally.
The history of inflation dynamics demonstrates that rising prices begets higher prices – 2% inflation begets 2.5% that begets 4%. Interestingly, the Fed appears to have the mindset that rising energy prices will work to crimp consumption, thus providing a drag on overall economic activity. But this is much too simplistic at best. Using rising energy prices as an example of inflationary dynamics, we can envisage how higher gas prices lead to larger Credit card borrowings at the pump. Governments simply run bigger budget deficits to finance huge energy purchases. Businesses and homeowners increase overall debt levels to indirectly finance rising energy outlays. Higher fuel, heat and cooling bills crimping household cash-flow? No worries, just take out a larger home equity loan. For the economy as a whole, we borrow more and run larger trade deficits. At home and throughout the world, surging energy prices foster a borrowing and spending boom as new sources of energy are sought and developed.
Meanwhile, global central bankers maintain ultra-low interest rates, foster abundant liquidity, and bolster vulnerable Credit systems. As such, it is difficult for me to imagine an environment more accommodative to mounting inflationary forces. The Fed’s punchbowl needed to have been removed before rising house prices led to energized borrowing, buying and inflationary spirals in key housing markets. The punchbowl should have been pulled away before rising costs for services such as tuition and medical care led to rising borrowings and altered inflationary expectations. And now the punchbowl needs to be removed before rising energy prices are similarly monetized with rising debt growth and generally rising system liquidity. Instead, rising energy prices will be passed along to consumers, businesses, and governments in a significant escalation in inflationary dynamics. Inflationary pressures will now be dispersed much more broadly throughout the economy, likely only boosting system-wide debt growth. The Fed is now clearly accommodating generalized inflation.
We really don’t know much about inflation these days, but we are learning. Many argue that energy usage as a percentage of GDP is much less than during past decades, hence rising energy prices are much less of a concern today. I think we are already witnessing that the key dynamic today is instead the resiliency of demand. And we have witnessed how the Credit system easily adapts and accommodates rising home prices. Why should energy prices be any different? And globally, fueled by our annual $600 billion current account deficits, and potentially thriving domestic Credit systems, there is every reason to fear that we will be competing for our energy requirements with many “liquefied” competitors.
Surging energy prices likely mark a major inflection point for inflationary processes, to much more broad-based price gains. Still, I hesitate to focus on traditional notions of inflation. I would continue to expect that wild price swings and general global monetary disorder remain the key inflationary issues. And when selling related to the unwind of the crowded “reflation trade” abates, I would not be surprised by a resumption of price gains and some wild price spikes throughout global commodities markets. Asian markets were percolating again this week, and I see the Asian boom – with its strong inflationary biases – poised to prove as resilient as the U.S. housing sector (with its strong inflationary bias).
And when it comes to walking tight-ropes, well, the U.S. bond market confronts a very difficult balancing act. On one side, the Fed is promising baby-step gradualism and perpetual accommodation – steep yield curves and irresistible spread profits in perpetuity. But on the other side is the clear possibility that a runaway global Credit Bubble stokes a booming global economy, with pricing pressures surprising on the upside. And if the tepid dollar rally over the past few months proves to be but a bear market rally, then things could turn rather interesting.
In the end, I expect the Inflation vs. Deflation debate to be largely determined by the status of the dollar. And I don’t see the dollar on firm footing. There are some crucial flaws in reasoning with respect to the Greenspan Fed’s hope that a global inflation will assuage U.S. imbalances. First of all, a global Credit boom implies the loss of control of inflationary process. Second, the nature of global inflationary manifestations will – because of differing economic, social, institutional, regulatory and political structures and biases – be of a different nature than the seemingly benign asset-variety inflation characteristic of U.S. “disinflation.” Third, there is the distorted U.S. economy and runaway U.S. Credit system unknowingly providing the liquidity to stoke a significant global inflation at any point that such dynamics take firm hold. And, fourth, there is the Achilles’ heel of a highly leveraged U.S. financial sector both complacent and acutely vulnerable to an inflationary shock.
Thus far, rising rates have tended to support the value of the dollar. However, if our foreign creditors come to recognize the vulnerability of the U.S. financial sector to the unfolding environment, the risk of simultaneously sinking bond and dollar prices could prove unnerving. Would a sinking dollar incite a flight of liquidity to non-dollar assets and markets (an environment with heightened inflation risk for the U.S. economy), or would sharply rising rates and U.S. de-leveraging render the entire linked global Credit system impaired (with the attendant risk of financial dislocation and debt collapse)? Is the expanding global securities-based Credit system sustainable or is it just a sideshow component of the fragile U.S. Credit Bubble? As I noted above, there is a great deal we simply don’t know.
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