Not So Fast on the Deflation Talk

By: Michael Ashton | Thu, Apr 25, 2013
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I wonder how quickly all of the calls of "deflation!" will turn into calls of "hyperinflation!"

After gold was pummeled $200 in two days on April 12th and 15th, there was a proliferation of commentators who suddenly declared that inflation fears were in full flight. Although the decline in inflation swaps to that point was mainly attributable to the decline in energy prices (subsequently, some air has indeed come out of implied core inflation, but still there is no deceleration in inflation, much less deflation, priced in), the chorus of "I told you so's" was deafening and many were encouraging Chairman Bernanke and other central bankers to take a victory lap. After the disastrous 5-year TIPS auction on April 18th I could almost hear Darth Vader saying "strike down the 5-year breakeven and the journey to a deflationary mindset will be complete."

Well, not so fast. Since that point, gold has recovered about $100 in rallying six out of the last eight sessions. The 5-year breakeven has recovered from 1.94% to 2.15% (although to be fair about half of that was due to the roll). The 10-year breakeven also bounced 14bps, and is back above 2.40%. Today, every commodity in the DJ-UBS index, with the exception of Coffee, rallied.

Why? What has changed over the last week and a half? Nothing important; if anything, the data has been weaker than the data preceding the washout. And that fact, I continue to think, is a fact the salience of which remains ungrasped by central bankers. Unless it's by sheer coincidence, global growth simply isn't going to explode upward while incentive structures are so bad and governments consume such a large part of the economy. And as long as growth doesn't explode higher, central banks will keep easing, because - despite almost five years of contrary evidence - they think it helps growth. I believe the only way that global QE stops is if central banks come to understand that they aren't doing any good on growth, and are doing much harm on inflation, though with a lag.

I am not terribly optimistic that such a eureka moment is nigh, especially when the economics community is so subject to confirmation bias that a technical washout in gold can provoke hosannas.

An April 12 article in the Washington Post highlighted recent research that indicates a one-percentage point increase in unemployment makes us feel four times as bad as a one-percentage point increase in inflation. This is not particularly surprising, at some level, although I greatly suspect that the results are non-linear - but I am not shocked that it feels worse to see people lose their jobs (or to lose one's own job) than to absorb slightly higher price increases.

But the article goes on to argue that "Such findings could have significant implications for monetary policy, which until the most recent recession has primarily been concerned with controlling inflation. But now some central banks are speaking of allowing inflation to rise or stay slightly above their usual targets in hopes of bringing down unemployment." The idea the article is proposing is that it is incorrect to balance evenly the (inherently conflicting) mandates the Fed is tasked with to seek lower inflation and lower unemployment; they should favor, according to this argument, lower unemployment.

There are several flaws in this argument, but I believe it is likely that the Fed more or less agrees with the sentiment.

One flaw is that the damage to inflation comes in the compounding. If unemployment is 6% now and 6% next year, there has been no change. But if inflation is 6% this year and 6% next year, then prices are up 12.4%. And if it's for three years, it's 19.1%. How many years of that 1% compounding inflation do you trade for 1% incremental change in unemployment?

A bigger flaw, in my view, is that central banks don't have any important control over the unemployment rate, while they have important control over inflation. It may also be the case that a 1% rise in background radiation levels makes people feel even worse than a 1% rise in unemployment, but that doesn't mean the Fed should target radiation levels!

Moreover, even if you think the Fed can affect growth, it is still true that for big moves in these numbers (because we really don't care so much about 1% inflation change or 1% unemployment change, after all) the central bank's power to cause harm is clearly much larger in inflation. It is possible to get 101% inflation, and in fact many central banks have done so. No central bank has ever managed to produce 101% unemployment.

I doubt that commodities and breakevens will go higher in a straight line from here. And every time there is a break lower, the deflationists will call for the surrender of the monetarists. But I do wonder if this latest break is the worst we will see until there is at least some sign that QE is going to end.


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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