The Inflation Tipping Point (Part One of Four)
The concept of a “tipping point” can apply to a wide range of phenomena. One classic example is that of a crowded theater slowly filling with smoke. At first, perhaps only one person notices the smoke and, comforted by the fact that others remain calm, remains seated, if slightly on edge. But then a handful of others also notice and become concerned.
Finally, at some point, these folks stop watching the show and instead start watching each other. As the growing concern across the theater becomes evident, someone finally makes for the exit, triggering a rush by others. Yet many of those rushing out might not have noticed any smoke. The critical point is reached not because more people notice the smoke; rather, more notice changes in others’ behavior and thus change their own.
The danger of inflation for economies and financial markets can also be understood in this way. As prices begin to creep higher, a few investors, businesses and households begin to notice. Rather than just going about their business as usual, they begin to watch the behavior of others more closely. Finally, a handful of economic agents suddenly change their behavior in a significant and highly visible way, triggering similar responses by others, who might not even have noticed that prices were rising.
What sorts of behavioral changes might those be? Perhaps investors begin to favor assets which protect against inflation. Perhaps businesses take out loans in order to finance stockpiles of inventories, in anticipation of higher prices. Perhaps consumers begin to do the same with durable household goods. By these very actions, investors, businesses and consumers all begin to reinforce a vicious inflationary circle, driving up prices for a broad range of goods. Regardless, once the inflation tipping point is reached, the rush to the exit–to protect against rising prices in some way–is likely to be disorderly and dangerous for the economy, with obvious consequences for financial markets.
Cast your eyes around the globe and it is clear that, in a growing number of countries, tipping points have already been reached. Since early last year there have been occasional food riots in various emerging market economies. The revolutions in Tunisia, Egypt and those brewing elsewhere at present reflect not only a persistent sense of illegitimacy of autocratic rule in much of the Muslim world but also the reality of rampant food price inflation in the souk (marketplace). While poverty is always a potential source of instability, when even the nascent middle-class in an emerging economy finds it is struggling merely to put food on the table, it is unlikely that the political order can remain unchanged for long.
The glaring reality of commodity and consumer price inflation around the world has now begun to shift the terms of debate between those expecting a prolonged deflation and those anticipating a transition to inflation in the aftermath of the global financial crisis of 2008. To understand why, let’s briefly explore the background of this debate and then turn to recent developments.
Before we do, we need to understand clearly the difference between monetary inflation/deflation, credit (or asset) inflation/deflation and, finally, commodity or consumer price inflation/deflation. Monetary inflation/deflation is the easiest to define as the supply of narrow money under the direct control of the central bank. (This is in contrast to broad money, which is created by bank lending).
Credit (or asset) inflation/deflation is more difficult to define because there are so many different forms of credit, ranging from bank time deposits–a form of broad money–to loans, leases or other forms of secured or unsecured debt. This is made all the more complicated because banks don’t normally mark their assets to market. Indeed, during the financial crisis, regulators gave banks additional flexibility to mark assets to “make-believe” rather than actual market prices. Whereas the price of a dollar is a dollar, that of a loan, a bond or other risky asset is uncertain and fluctuates with investor confidence that the issuer of the asset will be able to make the contracted interest and principal payments.
One way to approximate growth in credit (or asset) inflation/deflation, other than to follow broad money aggregates, is simply to look at the growth in bank lending, marked as is, be it to market or make-believe.
One reason why we can simplify in this way is because policy-makers in major economies have made it crystal-clear that, to the extent that financial institutions are at risk of insolvency, they will be bailed out in some fashion, such that the market price of distressed assets will never be properly marked-to-market but, rather, monetized over time. As such, it is not a great leap to assume that the growth (or shrinkage) in bank lending in general is reasonably indicative of whether credit inflation (or deflation) is taking place. Finally, there is commodity or consumer price inflation/deflation, normally measured by price indices.
But such indices are at best approximations and, at worst, are designed in ways which understate real world price inflation through so-called hedonic adjustments, substitution effects or by or underweighting or excluding entirely volatile components such as food and energy.
To be continued in Part Two of Four…
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]