No complaints and no excuses – inflation is on the way

March 28, 2012

By Laurence Copeland. The opinions expressed are his own.

In 1997, when Alan Greenspan famously pointed to “irrational exuberance” in the U.S. stock market, he nonetheless failed to follow up by doing what, according to an oft-quoted predecessor, is the critical task of a Fed Chairman: “taking away the punch-bowl just as the party gets going.” In fact, when the tech stock bubble burst in early 2000, he cut interest rates, and did the same again, more forgivably, in the aftermath of 9-11. The result of this laxity, emulated by the UK and Japan, was a new global bubble, this time mainly in real estate.

When the new bubble duly burst in 2007-8, the preferred “cure” for the hangover was the same as before  – only a far far bigger headache required a far far bigger dose, newly bottled and relabelled QE. The result has been predictable – a reinflated bubble, this time in commodities (especially oil and precious metals) and in nominal assets: short term debt (Treasury Bills etc), long term debt (gilts, some corporate debt), and worst and most menacing of all, in money itself, which is now grossly overvalued too.

The most convincing evidence comes from the index-linked gilts market where the real yield, which was over 4.5 percent at the start of the 1990’s, is now below zero, which means that investors are lending to HMG in exchange for the cast-iron guarantee that, for every pound of spending power they sacrifice today, they will receive less than a pound ten years from now.

Look at the message this conveys.

It seems that investors are so worried about inflation, and so mistrustful of the QE-inflated price of conventional gilts, they are willing to pay £1 for 99p of spending power in the future. Better a safe 99p, than risk getting only 20p in a decade or two, which was the reward to the folk who were patriotic enough to buy unindexed gilts during World War II.

No wonder the Chancellor is thinking of issuing 100-year conventional gilts ostensibly to “lock in” the benefits of Britain’s international “safe haven” status. The sordid reality, however, is that the prospect of paying only 3.5 percent on a 100-year bond looks to Whitehall like such a bargain that the temptation is irresistible to foist it on the banks, pension funds and insurance companies. These institutions provide a captive market forced in any case to invest in gilts by regulations, which are anyway being progressively tightened for prudential reasons.

This is a zero-sum game. The current level of yields is either good news for sellers (the Government) or for buyers, and the situation of the two sides is nowhere near symmetric, because by issuing conventional gilts the authorities are betting on inflation, which in the long run is within their own control. Insofar as they are betting against their own monetary policy, they are making their long run intentions crystal clear. From now on, no complaints and no excuses, the red flags are flying, we have had our warning: inflation is on the way.

Nor should it come as a surprise, because the direction of drift has been clear for the past five years, with Britain’s inflation rate stubbornly high and the pound apparently settled at its post-Lehman level of $1.60 and 1.15 euros, compared to $2.00 and 1.45 euros in 2007, in spite of the efforts at competitive devaluation all round the globe.

The Bank of England’s Monetary Policy Committee still advertises its 2 percent long run inflation target, but after a 3-year overshoot, it is hard to take it seriously. Along with most of my colleagues in the economics profession, the MPC are confident that, even with output  expanding as  we recover from the recession, it is only a matter of time before our supposedly high level of spare capacity pulls inflation back down again. I am not at all convinced.

In the first place, while the 2008-9 output contraction was the steepest since the 1930s, unemployment has so far risen by no more than in a typical postwar business cycle downswing, so productivity  must have fallen in the last two or three years. Secondly, with indexed welfare benefits, stagflation – the combination of inflation with stagnant output – must have seriously damaged the will to work, because it raises what is called the reservation wage, the pay level required to make it worth taking a job. Unless private sector pay rates keep pace with inflation (and therefore with benefits), firms will be unable to recruit labour in the upswing. The result will be that, when demand increases, wages will have to rise, causing further inflation.

So when will demand increase? The answer depends on how soon the billions of pounds which have been pumped into the banks are finally released as loans to the corporate and household sectors. I have no idea when that will happen, but I can only say that, once it starts, it is likely to gather speed like an avalanche, pushing inflation up very suddenly indeed and probably catching the authorities on the hop.

In the meantime, if the government is so sure that the situation is under control, why issue 100-year gilts? Why not more index-linkers? There is certainly a ready market for them. Given the nature of their liabilities, the pension funds ought to be holding inflation-proofed assets, so they could be expected to snap up the new issues with alacrity – even at yields of minus 0.25 percent.

The only possible conclusion is that, from the Whitehall perspective, 3.5 percent over 50 years makes the real yield on conventional gilts even lower than on the index-linkers, so we would be best-advised not to trust ministerial assurances on inflation, at least not until the authorities provide a hostage to fortune by issuing more indexed debt. Whenever the issue is raised, they assure us of their opposition to inflation, but look at it this way: would you back a boxer if you knew he was betting heavily on his opponent?

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