Inflation & Gold (Photo credit: Paolo Camera)
Sept 17th
The Fed Prints Money – But Where Is The Inflation We Predict ?
Monetary stimulus works through decreasing borrowing cost or devaluing currency. The former works if there are borrowers who respond to lowering the interest rate. The U.S. household sector suffers high indebtedness. Its debt appetite is low. The U.S. corporate sector is sitting on a record cash level and isn’t likely to borrow and invest just because the interest rate is a little lower. The U.S. government suffers a high fiscal deficit and cannot increase it due to political deadlock. The dollar is strong due to the euro debt crisis and growth recession in emerging economies. QE3 may cheapen the dollar a bit, but won’t be enough to make a significant difference because Europe is in recession and the growth rates in emerging economies are being halved.
QE3 will merely exaggerate bubbles that have emerged in some areas. The S&P 500 is close to an all-time high despite a weak U.S. and global economy. Internet stocks, for example, have valuations in the stratosphere. Manhattan flats are surging in price again. If QE3 makes a difference, it is through making bubbles. While there may be some gain in the short term, it will lead to bigger problems down the road.
The Inflation-Money Lag
When the economy is weak, most people have difficulties seeing inflation coming. The 1970s taught us that loose monetary policy could lead to high inflation in a weak economy. Inflation expectation alone can turn money supply into inflation. It takes time for the expectation to take hold. However, loose monetary policy has an immediate impact on the prices of traded commodities, which would feed into inflation quickly. When people see inflation despite a weak economy, they will adjust their expectations. The expectation eventually becomes the main inflation driver.
Globalization and financial crisis have increased the lag between inflation and money supply. The former makes supply global while demand remains local. Unless the exchange rate moves big, inflationary pressure can be suppressed by rising imports. When all countries loosen monetary policies, competitive devaluation occurs. Hence, the risk of big devaluation from loose money is reduced. Inflation is cooked in the whole global economy. In a larger economy, the lag between inflation and money is longer.
Financial crises cripple the balance sheets of some economic players. Money turns into inflation when economic entities borrow and spend. When economic entities are not in a condition to borrow, the transmission from money to inflation slows. The debt crises in developed economies since 2007 have exposed the precarious financial conditions of their governments and households. They are not in a condition to take advantage of low interest rates.
While the lag between money and inflation is longer this time, it is occurring where supplies are limited. Food products, for example, can respond quickly. The prices of soybean and corn have surged this year. The trigger is the drought in the United States. However, loose monetary policy has amplified the price reaction. Oil is another example. Despite contracting demand, oil prices remain elevated. Brent crude trades around US$ 115 per barrel, 5.5 times the average in the 1990s. High food and energy prices hit low-income people hardest
Inflation Hedging
Supply expansion decreases the attractiveness of an asset for inflation hedging. High prices due to bubbles have increased supplies in many assets and commodities. Their prices could underperform general inflation.
Oil performs better than iron ore because its supply isn’t rising significantly. Unlike steel, oil can’t be recycled. Hence, its supply and demand balance is more favorable to its price. In the commodity space, the stocks of oil companies could be good inflation hedges.
Because most assets good for inflation hedging are already inflated, one may have to adopt a dynamic hedging strategy. Inflation is a process. Paper money erodes gradually in value. Holding onto cash is still good for now but a better place for your money is in gold, oil and the companies that produce those commodities.
Caixin
