Will Debt Monetisation bring Inflation?
Updated: Apr 2, 2020
In order to address inflation concerns from Central Bank balance sheet expansion, I analyse the broad description of inflation, it’s recent behaviour and current market expectations, to determine future risks to wider risk asset prices.
Concern has been raised that money printing/Central Bank (CB) balance sheet expansion will bring inflation.
There are two types of inflation: the narrow Consumer Price Inflation (CPI), that the market and CBs spend far too much time analysing, and Asset Price Inflation (API), that too few people think about.
A proper definition of inflation considers the growth of money (and debt) versus the growth of assets, goods and services.
Recent evidence shows that following CB balance sheet expansion leads to high API and more muted CPI (which remains at or below CB targets).
An economic recovery with unchanged global trade should allow for further inflation of assets with continued low CPI.
The US and UK inflation markets are currently pricing that there will not be a lasting short-term deflationary shock, whilst US and EUR long term inflation expectations are very low. The market thus expects an economic recovery with unchanged global trade.
Should assumptions on recovery and global trade change, the inflation curve could give some early signals on future risk asset price trends. Like real yields, the inflation markets should be monitored very carefully.
Introduction
There are deep rooted concerns that the announced Central Bank balance sheet expansions will lead to much higher inflation. This is straight out of Econ101 and brings fears of what Adam Fergusson describes in his excellent book “When Money Dies: the Nightmare of the Weimar Collapse”. But is that really a possibility? To help answer this question, this post looks at a proper definition of inflation, the historical evidence and then confront these with current market pricing in the inflation swaps market.
Inflation
Inflation is often defined rather simplistically as the change in price of a good or service. A proper definition is “the change in the amount of dollars required to buy a fixed amount of goods or services”. For example, if 2 people only have $100,000 to buy the only house in town, then that house is worth $100,000. If one gets a mortgage for $10k, then the house can go up to $110,000 in value, leading to a 10% yoy house price inflation. The huge increase in Household debt over the last 30 years explains in a nutshell the global housing boom in that period. Where debt grew more, house prices grew faster (USA, UK, Australia, Sweden etc), whilst relatively more conservative countries with much lower Household (HH) debt saw prices appreciate at a slower level (Japan, Germany, Switzerland).
Inflation is a word that covers many items, but because Central banks have a narrow mandate to ensure that Consumer Price Inflation (CPI) is maintained at a certain level (usually c. 2%), financial market participants narrow inflation to CPI. CPI is purely a calculation of the average monthly and yearly change in prices of a basket of goods and services that an average consumer purchases. Below shows an example for the US.
There is of course inflation of assets, be they stocks, bonds, commodities, vintage cars, art etc., and the change in price is naturally also a function of the change in money available to buy those items. Compared to all the analysis of CPI, there is too little focus on asset price inflation and its causes - there is no Asset Price Index (API). Central Banks avoid discussing meteoric rises in the price of Art, Stocks or 100 year bonds, or question whether debt and its consequences is the reason for their rise (e.g. debt/equity buybacks). Has the Fed ever considered raising rates to reduce the rise in corporate leverage? Not in the recent past it would seem!
Inflation is something that covers both Consumer Baskets as well as other Assets.
Historical Evidence
A conundrum arose when “inflation” did not rise as predicted by economic textbooks when the FED, ECB, BOJ and BOE (and others) enacted their QE programs. That is certainly true for Consumer Price Indices across the Developed Markets, as can be seen from the left chart below, which plots core CPI for the US, Eurozone, Japan and UK (I use core to take out the volatile and mean reverting impact from oil and food).
Ever since the BOJ started its QQE and Yield Curve Control, Japan's CPI has oscillated around deflation. Europe has remained in disinflationary territory despite multiple QE and repo financing operations. But in that same time period stocks (right chart, normalised at 100 in 2009) made very large gains, outperforming the rise in profits (see SocGen’s Andy Lapthorne’s brilliant work on this). The same strong price appreciation was seen in corporate bonds (whose credit spread tightened dramatically), real estate, art, cars etc etc.
The historical evidence is that money printing does indeed bring inflation, not the CPI type that Central Bankers are concentrating on, but API. And by only focusing on the former, and ignoring the latter, Central Bankers have set policy far too loose allowing leverage to rise to levels that brought the financial instability that we are witnessing today.
Historical CPI data from Japan, the GFC and 2011/2012 peripheral crisis gives a good indication of what happens to CPI following a serious financial shock. The main takeaways are:
The reduction in energy prices causes a substantially larger decline in the headline rate compared to the core rate. Base effects will then mean revert the headline rate upwards to the core rate (US left, EUR right).
Core inflation rates decline below the pre-crisis levels as the reduction in demand outweighs the decline in supply.
The UK RPI should fall much further than other CPI rates due to the way real estate inflation is calculated (which has a high basket weight).
CPI can be lower than expected for much longer than expected (Central Banks’ forecasts over the last 10 years have been woefully incorrect, erroneously predicting a rise in inflation to target levels).
The above is only recent history - what about longer term history? What about BEFORE Japan became an exporting powerhouse, disinflating the price of goods globally (1990s onwards), and BEFORE China was part of the WTO (2000s onwards)? Pre 90s, when globalisation was small and trade barriers were higher, a large part of GDP was generated internally, so supply and demand shocks had larger impacts on CPI and API than today.
Will Covid19 cause a reduction in globalisation at a time when domestic supply will be reduced? Case studies of countries printing money WITH rising trade barriers demonstrate that inflation is indeed generated because the reduction in supply is greater than the reduction in demand (See James Montier’s excellent paper on this subject on the GMO website).
If this was to occur, then there would a very different investment paradigm: whilst asset prices might rise, real prices would be flat or negative. Bottom left chart shows the two spikes in US Headline CPI in 1973-75 and 76-81, the centre chart shows the House Price Index for the US (Blue) and UK (Green) during the second 1976-81 period. Whilst house nominal house prices soared, REAL house prices in this period were relatively flat/negative (right chart).
Market pricing
The US, Eur and UK inflation swap markets are linked to the CPI basket data (RPI in the UK). Like nominal swaps, there is a curve to 30 years which gives market expectations for future inflation in the short, medium and long term.
Medium term 10yr inflation swap rates in Eur, UK and US have all plummeted in 2020 with the decline in oil and equity markets. Indeed, the correlations between oil, inflation swaps and equity indices that held in the 2008 and 2018 equity sell-off were maintained in the recent equity sell-off, showing how being SHORT inflation remains one of the best equity hedges (like AUDJPY and to a lesser extent Gold). As the Covid19 struck, the starting 10yr inflation swap levels for the US and Eur were far below the levels pre GFC, so new lows were made in EUR and US. But what does this say about the future?
Forward inflation rates, i.e. future CPI market expectations, can be deduced from the spot inflation curves. A forward inflation curve depicts what the market expects inflation to be over the next time period, for example 10 years. The charts below show, for each country:
The current core inflation rate in Red (EUR 1.2%, US 2.4% and UK RPI 2.8%).
The forward curves at previous times of very low inflation expectations (Dec08, Feb16 and Jun19).
Today’s forward curve in black.
These charts have some important stand outs:
In general, the market is currently not concerned about the emergence of inflation, as long dated forward inflation expectations are below the 2% Central Bank targets (c. 3% RPI in UK). Therefore, the recent sell off in nominal bonds is not due to inflation concerns.
For the EUR and US, future medium-term inflation expectations are currently lower than previous times of inflation concern.
The US and UK inflation markets do not expect the current Covid19 pandemic to cause the same level of disinflation seen in those countries in 2008. That suggests faith in a decent recovery.
The UK is the standout, as inflation expectations are far above those seen in 2008 AND above the current core rate. I suspect this is due to concerns that the recent GBP devaluation will bring imported inflation, which would be erroneous as that would only be a short-term impact as base effects would cancel that inflation 1 year later.
CONCLUSION
Recent past evidence suggests that the extraordinary measures to expand Central Bank balance sheets should lead to an important rise in Asset Price Inflation, whilst CPI remains at or below the Central Banks’ target. Inflation markets in the US and Eur currently price this scenario, i.e. that inflation will remain low for the next 10 years, which assumes a reasonable recovery, no reduction in supply and for global trade to remain at existing levels.
Any changes to these assumptions should lead to either expectations of deeper disinflation in the short term (from a poorer consumer recovery) and/or higher longer-term inflation (if trade barriers rise and/or supply gets cut). If the latter starts to occur, then longer dated inflation swap yield levels have a long way to rise from the historic low levels, which would make investing in any assets to make real returns far trickier.
More importantly, a substantial rise in inflation yields would go against the current Central Bank policy to keep government NOMINAL bond yields low (Nominal Yields = Real Yields + Inflation Yields).
IF, and this is not the case at the moment, inflation yields were to rise, then Central Banks would have to accelerate bond purchases to drive REAL RATES even lower to combat this rise in INFLATION YIELDS (one of the few things that CBs cannot manipulate). This would push asset prices even higher with the unintended consequence of a depreciating currency, which would impact inflation….in other words, this would fan volatility.
Going forward, as real government bond yields need to be monitored for equity and corporate bond investors (see previous blog posts), inflation expectations will also be key to monitor. Both will give clear indications on future market volatility: real yields with regards to the government’s ability to finance itself without sequestering funds from the private sector; and inflation yields to ensure that real returns will be positive in a low volatile environment.