Price Pressures

How to import inflation the British way

TOMAS JELF, CHIEF ECONOMIST, PROLOGUE CAPITAL

So, the Great Global Recession is over. Inevitably, some investors’ fears have subsequently shifted to the dangers of the unintended consequences that may come from the very policy measures that saved the global economy from collapsing. They fret that high inflation will once again scorch the economic landscape. It is easy to sympathise with the view that the Great Global Inflation is the inevitable result of the dramatic policy measures undertaken during the past year or so. After all, aggressive monetary and fiscal expansions have often contributed to high inflation rates in the past.

The growth rates in narrow monetary aggregates are truly awesome. In the US the monetary base has more than doubled over the past 12 months and M1 money supply is growing at its fastest annual rate since the Federal Reserve began publishing the data in the 1950s. Indeed, narrow monetary aggregates are growing at record levels in several OECD countries and major emerging markets. So far the surges in narrow monetary aggregates have had negligible effects on price developments because of the collapse in money multipliers. But many investors fear that once credit growth resumes and money multipliers rise, the inflationary impact from increases in narrow money will hit economies across the globe.

The fiscal deterioration has been equally remarkable. The fiscal deficit, i.e. the share of spending that is financed by debt, has moved into double digits in the US. The OECD estimates that on this definition the US fiscal deficit will be 22.8% this year and 23.5% in 2010. Not since the 1970s and early 1980s has the nation experienced deficits of this magnitude. The fiscal deficit in the UK should reach 23.5% already this year, followed by 22.8% next year. Japan, meanwhile, continues to suffer from what seems to be chronic deterioration in its public finances. On average the Japanese fiscal deficit has been 12% during the past 20 years, a record only exceeded by Greece among developed economies. Similar trends can be observed in a multitude of other economies, thankfully to a lesser degree.

All this said, our work suggests that it is a mistake to expect that a resurgence in inflationary pressures will be coincidental across the globe. Instead, with both inflationary and deflationary forces at work, there is a high probability of a differentiation in inflation rates as the global recovery evolves. A key task for successful money management over the next few years will be to determine how that differentiation plays out.

The UK runs the greatest risks among developed economies of accelerating inflationary pressures. We are considerably more sanguine about the outlook for the US and the Eurozone. Indeed, our work suggests that the tug of war between inflationary and deflationary impulses will continue in those economies for some time. Meanwhile, we remain confident that Japan will remain mired in deflation.

There are three reasons why the UK is more exposed to upside risk for inflation than other developed economies:

1.The Bank of England’s aggressive quantitative easing policy.
2. The government’s fiscal situation.
3. Currency weakness.

Quantitative easing
The Bank of England was the first central bank this year to engage in overt quantitative easing and has relentlessly pursued that policy ever since. So far, the Bank of England has printed a cool £143 billion and bought government debt with the money. To put that in perspective, Nomura Securities estimates this is equivalent to 125% of the British government’s gross debt issuance this year. The Bank of England is scheduled to purchase another £32 billion by the beginning of November, again with newly printed pounds. All in, the Bank of England’s purchases will amount to 12% of nominal GDP.

Other central banks have also engaged in overt quantitative easing, but not on the scale of the Bank of England. In the US, we estimate that the Federal Reserve’s $300 billion purchase of treasuries represents 15% of gross issuance this year, or 2.1% of nominal GDP. Add the $1.25 trillion purchases of mortgage back securities and the Federal Reserve’s buying amounts to 10.9% of nominal GDP. Only the last measure does the magnitude of the Federal Reserve efforts come close to those of the Bank of England.

The Federal Reserve has communicated its intention to end treasury purchases once its already announced buying plan comes to an end in late October. The central bank’s purchases of mortgage backed securities are also likely to stop when the current programme ends in March, barring a significant deterioration in the economic outlook. Furthermore, the Federal Reserve is currently engaged in a deliberate and careful attempt to explain how it intends to exit from the extreme policy setting at some undetermined point in the future. In contrast, the Bank of England has signalled that it may well expand its gilt purchases further.

The European Central Bank has largely avoided overt quantitative easing. While it is engaged in purchases of covered bonds, these account for a mere 0.6% of nominal GDP. Instead, its major efforts have focused on liquidity provision to the banking sector. The big difference compared to the Bank of England’s approach has been the lack of signalling effect; the European Central Bank’s operations have been more technical in nature and have thus received less attention from the general public.

While the Federal Reserve and European Central Bank have been aiming to maintain their inflation fighting credentials, the Bank of England seems to be working hard at becoming “credibly irresponsible”, as Nobel Laurate Paul Krugman quipped over a decade ago when dishing out some (unsolicited) advice to the Bank of Japan.

It is the credibly irresponsible facet that makes the overtness of the Bank of England’s quantitative easing framework so important. By openly pushing on with this strategy, the central bank should, in theory, be able to increase inflation expectations. Developments in the financial markets suggest that they may be succeeding. After all, the British pound has depreciated against every single currency in its trade weighted index since the summer while the gilt curve is the steepest – and break even rates the widest – in the developed world.

The fiscal deficit
The UK entered the recession with a weaker fiscal position than most other developed countries. In 2007, the fiscal deficit measured as a percentage of GDP was 3.5%, the fourth worst figure among OECD economies. That quickly deteriorated to 5.8% in 2008 and is estimated to be a whopping 10.5% this year. The OECD estimates that the equivalent numbers will remain above 10% in 2010. Of course, given that next year is an election year the uncertainty regarding future projections is unusually large.

The main point here is that the deficit is approaching a level that historically is associated with rapid increases in inflation rates. Granted, when measuring the deficit as a share of government spending, the UK is still some way from the 40% level that have been associated with hyper inflation [1]. Still, the current 23.5% level is a cause for concern, especially when it is largely underwritten by the Bank of England.

The fiscal position should affect the inflation outlook in two important ways. Over the medium term it should, just as the Bank of England’s quantitative easing efforts, increase inflationary expectations as economic agents realise that the temptation from the government will be to inflate away a good portion of the debt. In the near term, it should cause the currency to depreciate which will lead to imported inflation. Both factors are already in play.

Currency weakness
When overt quantitative easing was introduced by the Bank of England and the Federal Reserve in March the general understanding among market participants was that the success of the policy would be determined by the money multiplier, i.e. the extent to which the increase in narrow money would boost broad money. When the multiplier unsurprisingly collapsed many observers concluded that the quantitative easing policy was ineffectual. Those that came to that conclusion ignored a key transmission channel; the currency.

The combination, some would say interplay, of the Bank of England’s credibly irresponsible policy and the government’s large fiscal deficits have had a noticeable impact on the currency. As mentioned above, the British pound has depreciated against the currencies of all major trading partners since the summer. Indeed, we argue that the true success of the Bank of England’s quantitative easing policy is the close to 10% fall in the trade weighted sterling over the past three months.

Taking a longer term view, the trade weighted index is down over 25% since the onset of the credit crisis (see Fig.1).

prologue1

This sort of depreciation does matter. The UK is an open economy with trade volumes at 60% of GDP. Consequently, the economy, including inflation, is more sensitive to currency swings than larger economies like the US and the Eurozone. As a rule of thumb a 10% depreciation in trade weighted sterling pushes up CPI by 1% over the following two years. The equivalent numbers for the US and the Eurozone are 0.5% and 0.3% respectively. Put differently, the pass through from the currency to inflation is two to three times greater in the UK than in the two larger economies. As the UK becomes more dependent on imported energy this effect is magnified.

The hard data backs this up. Import prices lag the trade weighted sterling by roughly 14 months. More broadly, the impact from the weaker sterling has contributed to core goods prices, which constitute 31.2% of the CPI basket, moving into inflationary territory after twelve years in disinflation.

Investment conclusion
Investors who want to capitalise on the inflation outlook for UK discussed in this article have a number of instruments at their disposal.

• First and foremost, the UK has the oldest and one of the most established inflation protected government bond markets. The inflation protected gilts, better known as linkers, offer the holder inflation protected returns on the principal and coupon. The break even rate, that is the difference between the interest rates earned on nominal and inflation protected gilts, provide investors with exposure to fairly pure inflation premium. If the thesis laid out in this article is correct the break even rate should move higher in the UK both on an absolute basis and relative to break even rates in the US and the Eurozone.

• Second, the inflation premium in the nominal interest curve should continue to increase. That suggests that the gilt curve should remain steep and continue to go steeper relative to government bond curves elsewhere.

•Lastly, the weakness in sterling is likely to persist for some time.
The main risks to the outlook presented here are substantial and aggressive reversals of fiscal and monetary policies. The former is possible, but far from certain, following the general election next summer. A quick reversal of the latter is considerably less likely, particularly so if the new government engages in an aggressive fiscal clean up.

More generally, diverse inflation outcomes promise to be a rich source for returns over the next few years for fund managers with good foresight and the appropriate skill set. The UK is only one among several countries where this will prove to be the case.

NOTES

1. For an in-depth discussion on fiscal deficits and hyper inflation see Peter Breitholtz, ‘Monetary Regimes and Inflation’.

ABOUT THE AUTHOR

Tomas Jelf is Chief Economist at Prologue Capital, and was previously Chief Market Strategist at Nexus Capital, then sole manager for George Soros’ Quantum Fund. He began his career as a researcher at the United Nations and has a degree in political science from the University of Stockholm and a master’s degree in international economics from Bocconi University, Milan.