Thursday, April 15, 2004

Today's Inflation May Cause Tomorrow's Deflation

Asia Pacific: Today's Inflation May Cause Tomorrow's Deflation
Andy Xie (Hong Kong)

Today’s inflation is based on borrowed money that supports consumption in the US and investment in China via its impact on commodity prices. This situation cannot last because labor surplus kills inflation expectations. When the cycle turns down, demand can be expected to bottom lower than normal under a higher debt burden, while capacity would be higher than normal. This combination would lead to deflation.

The central banks may raise interest rates against cost-push induced inflation. This would be the right action for the wrong reason. Low interest rates have led to debt-induced bubbles that will worsen deflationary pressure later. The right reason for tightening monetary policy would be to contain asset bubbles in order to prevent future deflation.

What Is Causing Inflation?

Headline inflation data are picking up, raising fears that the global economy could enter a period of high inflation. This is an erroneous conclusion, in my view. The current inflation stems from rising commodity prices caused by property speculation, mainly in the United States and China, that spills over into consumption in the US and investment in China. The pass-through to consumers of higher raw material costs in production is much less than usual, due to the overall surplus situation. Because wages are not linked to inflation in the current environment, the inflation mostly redistributes income from households to producers and from downstream to upstream producers.

Many analysts point to loose Fed policy as the reason for inflationary pressure. The source is correct but the mechanism is quite different. Loose monetary policy normally causes inflation due to, as Milton Friedman put it best, too much money chasing too few goods. However, broadly speaking, this is not what is occurring. Because globalization and new technologies have greatly lifted global output potential, i.e., there is a big global output gap, monetary policy currently has much less impact on inflation expectations.

Instead, cheap money causes speculation in asset markets. In a global economy where potential supply is greater than demand, the equilibrium inflation rate should be low. Hence, nominal income growth should also be low even though real income growth would be high. Further, the income growth would shift disproportionately to low-cost producers. Hence, rich households face low income growth in today’s world. But as money becomes cheap, the rich households expect assets to appreciate, which would be logical if their income growth potential had not changed. This “money illusion” – cheap money with income potential unchanged – is causing rich households to speculate. This is what is occurring in many Western economies.

The Fed’s cheap money policy has made money available for China’s high growth economy. The combination has caused even greater property speculation in China. The expectation that Shanghai’s property prices would converge towards those of Hong Kong and Taiwan was the catalyst for China’s property bubble. The low US interest rate prompted Hong Kong and Taiwan speculators to jump on this ‘convergence’ trade. As Shanghai’s property prices have risen and the revenue to the government has enabled the city to grow rapidly, other cities have emulated the trend, causing a nationwide property bubble.

Why is this type of inflation different? Under normal circumstances, when a central bank prints too much money, everyone expects prices to rise and, hence, asks for a wage increase. The economy experiences a price-wage spiral, and the leverage in the economy’s debt-to-GDP ratio does not rise. The current type of inflation comes from the spillover of demand from property speculation funded by debt. The indirect nature means that debt rises much faster than GDP.

In the last three years, the ratio of net borrowing by the financial sector to GDP increase in the US was 3.6 compared with 1.8 in the 1990s, 2.3 in the 1980s, 1.5 in the 1970s, and 1.6 in the 1960s. In the past three years, every dollar increase in China’s GDP was accompanied by a US$2.50 increase in domestic credit compared to US$1.60 in the 1990s.

Smaller Impact of Commodity Prices on Inflation

Under normal circumstances, loose monetary policy causes commodity prices to rise in a wage-price spiral; commodity producers ask for more money because they expect production costs to rise. When looser monetary policy works through property speculation to increase demand, commodity prices rise because demand is greater than expected. It is much more difficult to pass through higher commodity costs in production to customers in such an environment.

Historical patterns would suggest 4% inflation in OECD economies at this point in the commodity cycle. But we are only observing about 1%. The same disconnect is happening in East Asia ex-Japan. If we use the early 1990s as a comparator, the inflation rate in the region should be 8-10% at this point in the cycle. But we are only observing about 3% based on the official data and 5% if we assume that China’s data understate inflation now.

Debt Deflation May Not Be Far Away

The global economy has experienced a positive capacity shock through globalization. The need to find an equilibrium should have caused a downward price level adjustment in the developed economies. Instead, monetary authorities, mainly the Fed, are using cheap money to fight this adjustment, causing a massive property bubble that creates superficial demand and stops prices from declining. However, as soon as the bubble bursts, the world will need a bigger downward adjustment because of the extra capacity formed during the bubble.

Most importantly, so much debt has been created that it may lead to debt deflation. Globalization would have caused benign deflation that benefits consumers and causes some industries to relocate to lower-cost locations. But fighting against this sort of deflation with bubbles and debts must lead to deflation. In my view, this is what happened in the 1920s after World War I.

When the global property bubble bursts, debt deflation could ensue. It is always possible that the Fed could create another bubble to postpone the inevitable. For example, direct purchase of US Treasuries to push the 10-year yield down to 2% could create another property bubble. However, the Fed may repent and Mr. Greenspan could retire. It may not be profitable to bet on the next bubble. ...Link

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