Inflation or deflation?

Posted on 05. Apr, 2010 by Steve Ohana in Weekly Focus | Comments Off

We have already emphasized that the weak link of the financial system is the G10 solvency issue. Despite the continuous rise in financial assets which may last farther out, particularly in the commodity complex, the solvency problem is still present at the heart of the financial system as reflected by a snapshot of Riskelia’s Radar on Risk Aversion:

The situation is unsustainable as we have stated that the required austerity policy–if ever carried out- in peripheral euro zone countries will eventually translate into a deflationary depression. Indeed, the imposed measures will involve wage reductions and competitive price drops. In turn, domestic banks will likely be hit because of the increase of the default rate in the private sector.

Let us introduce Treasury Inflation Protected Securities (TIPS) to better understand anticipated inflation in the face of increased sovereign solvency risk. TIPS are treasuries whose coupons and principal are revalued according to an inflation index, most often the CPI. They offer inflation protection to investors while being largely immune to deflation risk since a TIPS investor won’t receive less than the original principal. Therefore, the price of TIPS may be used to derive a so-called “real interest rate”, which is the implied yield of the security necessary to retrieve its quoted price. Then, we can use the relation:

Nominal Yield = Break Even Inflation + Real Interest Rates

to infer the “break even inflation” from the TIPS prices, a real-time indicator of the inflation rate anticipated by the market participants. In stable financial markets, where central banks keep control of inflation, the break even is very steady in time, representing the core inflation of the economy. But in uncertain bond markets such as Greece, Portugal and Spain, how did inflation breakeven evolve relative to the perceived default risk?

Sovereign solvency issues are strongly correlated to market-anticipated deflation. The chart below illustrates that the higher the CDS, the lower the breakeven rates: the two time series are correlated at -0.7.

Therefore, our analysis which contends that countries with solvency issues are subject to deflationary forces, is validated by financial markets in Europe: government insolvency constrained by strict budget balance rules and rigid monetary policy eventually leads to deflation. The increase in the so-called “real rate” does not reflect an increase in the anticipated real growth but an increase in the sovereign debt risk premium. In Europe, solvency issues lead to deflation which is partially alleviated by the euro currency depreciation (resulting in imported inflation).

On the other side of the Atlantic, the situation is more complex regarding inflation. The steps which have been taken since the 2008 financial crisis have been inflationary at least from a monetarist point of view. The Federal Reserve more than doubled its balance sheet in only two years and has never reversed this course since then, despite its pledge to do so in the near future:

The conjunction of monetary expansion and budgetary fiscal deficits have been successful at boosting financial markets, commodities and eventually the real economy as reflected by the continuous improvement of Purchasing Manager polls and the gradual employment recovery. Long-term government real interest rates sharply increased as illustrated by the chart below:

From December 2009 onwards, nominal yields increased by 66 bps, 58 of them due to the “real interest rate”, the remaining 8 bps due to break even inflation rate. In this case, the real rate increase probably reflects an increase in the anticipated growth. As commodities go on rising, an inflation catch up is possible in the US as revealed by the strong causality running from commodities performance to CPI variations in the recent years:

A sharp increase in yields becomes a credible scenario in the US if financial bubbles go on swelling.

Yet, there are powerful deflationary forces as well in the US because the financial system is still in a deleveraging mode. The liquidity injected into the financial system remains  idle in the banks’ reserves and credit is still contracting at an unprecented pace.  The “liquidity trap”of John Maynard Keynes is still at play in the US and in most of the advanced economies.

In the long term, a stark inflationnary crisis (with a sharp dollar depreciation) may be triggered by a decision to monetize the US public debt if the unsustainable fiscal path is not rapidly curbed by expense reductions and tax increases (with deflationary effects in the medium term…).

In China, inflation is obvious in all sector of the economy as stated by China’s central bank. Real estate prices are expanding exponentially and total bank loans are still growing at an impressive rate despite two consecutive rises in the reserve ratio requirements of major Chinese banks since January 2010:

In short, Europe is turning to deflation, the US has a moderate risk of inflation in the short-term and China faces a strong risk of uncontrolled long-term inflation. The unprecedented monetary and budgetary stimuli have eventually restored worldwide growth but the latter is shared unevenly in different parts of the world. Deflation and inflation are two sides of the same medal: fighting against the former increases the risk of the latter.

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