Inflation fears cooling off

by Levi Folk | September 6, 2008

The market’s preoccupation with rising inflation in the developed world appears to be ending. Hedge fund investors, convinced that history would repeat with 1970s-style stagflation, crowded into commodities since the start of the year and pushed commodity futures prices higher. This trend has now reversed and these positions are being liquidated. The focus has finally turned squarely on growth.

The global banking system is weak: It is undercapitalized due to massive writedowns on defaulting mortgage debt; and it is unable to lend adequately to sustain investment and economic growth. Without proper access to credit, these economies are likely to stay weak and even contract.

However, the corollary of this point is that inflation will no longer be a problem for central bankers. The European Central Bank raised interest rates this year to cope with rising inflation, but this move is likely to be reversed shortly. With the economies of Europe weak and domestic demand below potential (GDP and retail sales in Europe are both contracting), inflation pressures are receding.

Making the distinction between core and headline inflation is instructive—the difference between the two being food and energy prices. Central bankers like to remove energy and food prices from inflation to reduce the volatility of headline inflation when setting monetary policy.

Headline inflation has been outside central bankers’ comfort zones in the United States and Europe due to rising food and energy prices. U. S. headline inflation in July increased at a 5.6% annual rate and was the highest in 17 years. (In Europe, it was the highest in 16 years in July.)

Core inflation, however, has remained well-behaved, expanding at a 2.5% rate.

The U. S. Federal Reserve Bank cut the fed funds rate to 2% in response to major problems in the housing and banking sectors with the hope that a softening labour market would have little wage-bargaining power. That gamble proved right.

Oil prices shot up close to US$150 per barrel in the first half of this year. That trend has largely reversed on weak oil demand, contracting liquidity that has curtailed speculative investments, and increasing oil supplies. This fall in oil prices along with softer food and metals prices will appear in weaker headline numbers over the next month and probably thereafter.

Gold prices and bond yields, both barometers of inflation expectations, have both moved down. Gold has fallen in sympathy with the rallying U. S. dollar, weakening economic data, and sea change in inflation concerns by hedge funds and other speculators. Gold is trading close to US$800 per ounce and could conceivably break below this level.

The difference in yield between U. S. Treasury Inflation Protected Securities (TIPS) and regular treasuries is the lowest since August, 2003, at less than 2% for bonds maturing in 10 years. This difference is a signal of 10-year inflation expectations as priced into the bond market and it is pricing a fall in headline inflation.

This summer, the U.S. dollar has staged a rebound: imports have softened and exports expanded since the start of the year thus reducing the current account deficit and reducing the dollar supply. This move higher in the U. S. dollar is deflationary and will undermine gold prices further.

Dollar strength is causally connected to U. S. bank weakness through weak lending and softer domestic demand, according to a recent report by Smithers and Co. Ltd. The report suggests that U. S. bank lending problems are "accelerating," which is a portent of stock market and economic weakness and dollar appreciation over the next few months.

We are in to the second year of the credit crunch, and we do not appear near to the end. Liquidity may contract softly or strongly depending on the resolve of policy makers to stem the tide of losses. Either way, the near term prospects are deflationary for developed markets and inflation fears will soon disappear. Cash remains king in the developed world.