Price inflation approaching

Alasdair Macleod – 07 August 2013

There is some evidence in the UK of a pick-up in consumer spending, probably echoed elsewhere. There are two likely factors behind this, the first perhaps being seasonal, aided by the fine weather. The second is less obvious, but combines with the first to encourage purchases of big ticket items; and this is cheap consumer finance coupled with growing expectations of higher interest rates in the future.

Interest rate expectations are therefore fuelling demand for big-ticket items, such as autos and electronic goods, where the cost of credit has been cut to maintain sales. There also appears to be growing demand for fixed-rate mortgages, and thanks to banks willing to borrow short and lend long there are some very tempting refinancing deals available. In summary, low financing costs plus a decent summer is the basis for kick-starting economic optimism.

Economists are already revising their GDP growth expectations upwards. However, there is likely to be a growing tendency for prices to rise due to capacity constraints in companies that have bolstered their profits by withholding investment for the last three or four years. Consequently price rises will be greater than generally expected.

The situation in the US is similar, with an added factor. US consumers are more responsive to confidence in stock markets and property prices than in the UK, and here the news has been bullish. Interest rates are low, and they will rise, so buy those big-ticket items now. The cost of buying and financing the average house purchase has already risen an estimated 40%.

Governments and economists will think they have the recovery they have wished for. Unfortunately it will almost certainly be marred by price inflation greater than the increase in demand suggests. So while nominal GDP growth rates will turn out to be somewhat better than currently expected, the talk will be of temporary capacity constraints.

The end result is that while central banks will realise that price inflation is a growing problem they will be reluctant to use higher interest rates to choke off inflation. And if consumers see central banks are behind this curve, further consumer borrowing will be encouraged.

This leads into the second phase of inflation. The first was expansion of cash and deposit money and the second is its mobilisation. The price effect is likely to be dramatic as money shifts from Wall Street to Main Street (or in British terms, from the City of London to the high street). However, there is an additional currency effect which few economists factor in: markets begin to discount the future purchasing power of paper currencies, bringing anticipated and higher prices forward in time, while central banks appear to be reluctant to raise interest rates. The Volcker remedy of raising interest rates to choke off inflation is simply not a policy-maker’s option.

The central banks are bound to be more focused on the damage from rising bond yields to government deficits and bank balance sheets. They will also be acutely aware of the effect higher borrowing costs has on today’s high levels of consumer debt.

The conclusion is that the central banks’ inflationary response to the banking crisis five years ago is going to get considerably more difficult in the coming months as monetary inflation morphs into price inflation.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

2 thoughts on “Price inflation approaching”

  1. We are likely entering another period of inflation. If confirmed, will be followed by another recession. Rince and repeat. The Fed is a one trick pony.

    QE = Debt monetization. The Fed is foolishly applying the Phillips curve to US economy, where is has been shown (ref. below) to have no (positive) effect in the long-term.

    Inflation is always and everywhere a monetary phenomenon.
    —Milton Friedman, 1963

    Ref.: Re: Phillips curve economics
    Quarterly Review and Outlook
    First Quarter 2011

    “If the objectives of Quantitative Easing
    2 (QE2) were to: a) raise interest rates; b) slow
    economic growth; c) encourage speculation, and
    d) eviscerate the standard of living of the average
    American family, then it has been enormously
    successful. Clearly, with the benefit of 20/20
    hindsight these results represent the Federal
    Reserve’s impact on the U.S. economy, regardless
    of their claims to the contrary.”

    “One of the major tenets of Keynesian
    economics was the Phillips Curve, which posits
    a stable inverse relationship between the rate
    of inflation and the unemployment rate.”

    “Specifically, it contended that the unemployment
    rate could be lowered causing only slightly higher

    “Under the activist Phillips curve based
    policy, some reduction in unemployment was
    temporarily achieved. However, inflation
    accelerated much more than was anticipated, and
    the net result was higher unemployment and faster
    inflation, an outcome not contemplated by the
    Phillips Curve.”

    “Working independently in the late 1960s,
    economists Milton Friedman (1912-2006) and
    Edmund Phelps, who would both eventually be
    awarded the Nobel Prize in economics, determined
    that while the Phillips Curve was observable over
    the short run, it was not apparent over the long
    run. Economic experience in the U.S. proved that
    the tradeoff was ephemeral.”

    “The Bernanke Fed provides fresh confirmation
    that trying to substitute higher inflation for lower
    unemployment harms the economy.”

    “If the Fed’s goal is to limit unemployment, the path to
    success is to ensure low, not accelerating inflation,
    a lesson we have just learned once again.”

    [rinse and repeat]

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