Inflation More Likely in Germany, China than U.S., U.K.
December 22, 2009
by
“Inflation or deflation?” This is the question that markets have been wrestling with for the last year and will likely do so for another few. With reports of the record steep yield curves upon us, it should give us pause to ask which direction we are headed. Clearly central banks around the world are doing everything possible to ensure that inflation is at least positive, even though these steps might be detrimental to the long term health of their economies.
A look at industrial production for the U.S. and other major exporting nations does not seem to justify this view of rising activity. It is countries like Germany and China that are in an uptrend for production. As we saw last week, trade is gradually recovering, even after the end of some stimulus programs. However, it remains far off the pace of last year and unlikely to cause tightness in labor or the markets for raw materials any time soon. Furthermore, yield curves for various countries don’t correlate particularly well to the fiscal responsibility of their nations.
In cycles past a steep yield curve (higher interest rates for holding debt for longer periods of time) was seen as a bullish sign for an economy. Today it is reported as inflation is right around the corner. Yet a totally logical argument for inflation is hard to find.
U.S. interest rates have risen in the last month but remain far off 2009 highs. The rates for 10-year U.S. Treasuries are a good indication of expectations for the long term. It is fair to argue that if serious inflation does not arise within five or ten years of this crisis, you can’t blame policy actions of the last year for future inflation. Yields on 10-year Treasuries had dropped below 2.5% at the beginning of this year but began a steady rise to nearly 4.0% into June. Yields then slid back down to 3.21% in late November. In the past week they have hovered above 3.5%.
These yields do not reflect future inflation or economic growth simply the expectations of them. Unfortunately, you can not ascertain from the curve above how much is expectation of growth and how much expectation of inflation. For that you have to go to the Treasury Inflation Protected Securities (TIPS) market. I won’t go there for this article but suffice it to say inflation expectations are returning as they did last June. Yet, you have to ask, “Where is it coming from?”
Two theories of inflation pressure
Most inflation watchers fall into two different camps. The first, I will call the “Output Gap” camp. This group of investors and economists believe inflation is caused by scarcity in labor and materials. Inflation is only created when things become tight, in part, by rising prices of raw materials but more importantly by rising wages of workers. Most folks in this camp look at high unemployment levels and low production levels and conclude above average inflation is many years off.
I would call the others the “Money Printing” camp. They believe that inflation is caused mostly by an increase in money supply. The more money being created by governments and the private sector, the more there is to chase goods and services. This bids up prices and causes inflation. Clearly government deficit and debt levels for most industrialized nations are at or are headed to record levels for the Post-WWII period. Members of this camp look at government deficits of the U.S. or the U.K., remark about central banks printing money, and advise you to sell the dollar or pound and buy gold, the Yuan, or the Euro.
Inflation from the Output Gap perspective. If inflation was being driven by scarcity of materials and labor we would need to see at least one of two things: signs of a tightening labor market and/or increasing of production consuming raw materials. I won’t bother to graph the labor situation as most folks know that official unemployment in the U.S. stands at 10.0% with Europe only slightly better at 9.8%. Germany stands out in the EU with a rate of just 7.5%.
Some economies like those of Canada and Australia are actually adding jobs to the private sector while places like France unemployment is still rising. As discussed before the much reported decline in the U.S. unemployment rate was more due to assumptions than jobs added to the economy. That leaves industrial production.
Industrial production of German and Japan are returning but remain more than 20% off pre-recession peak. Industrial production appears to have bottomed in most major countries. In fact, it is the countries that saw the furthest decline that are staging the stronger month-on-month gains as of late. Yet Germany and Japan remain at production rates that are 20.3% and 21.8% off their monthly peaks in 2008. This figure is better in the U.S. and the U.K. 12.3% and 14.4% declines respectively but momentum may be stalling out in these places through. With capacity utilizations as at or near record lows in many countries, it is hard to argue for ‘tightness’ anywhere in the industrial process. The best argument can be made is for Germany but even that case would be weak.
Inflation from the Money Printing perspective. If inflation isn’t being driven by tightness in labor or production, we can to look at unfettered government spending as a source of inflation. The arguments for this are well reported. Governments are indeed spending money they do not have and issuing debt at record levels.
Japan, the United States and United Kingdom have serious structural deficit problems. Budget gaps are a combination of lack of revenue and increased spending. Japan, the U.S. and the U.K. are all on track for budget deficits as a percentage of GDP that exceeds 10%. In all cases, this double digit level is expected to be temporary but the return to pre-recession levels is far out into the future if at all.
Japan’s interest rates are half of its OECD peers. There are a few problems with this as the explanation for higher interest rates. There is a correlation for high government deficits with higher interest rates in the U.S. and the U.K. Yet the correlation breaks down in the case of Germany and Japan. Japan, the country with worst fiscal deficits and the largest government debt (already over 100% of GDP), has the lowest interest rates of any industrialized nation. Printing money has been going on for two decades there yet investors still flock to the yen. Germany, whose government spending is on much sounder footing has interest rates not that much different than those in the U.S. or the U.K.
And then there is China
Industrial production growth continues to outpace. According to official reports Chinese industrial production in November was up 13.8% over the prior year. This, of course, is as much a reflection on the weakness of last year as the strength of today. Above is a set of categories I have followed for prior articles that reflect production for both domestic and export demand.
Production in some categories like automobiles and steel has seen positive growth all year and is now setting new highs. Other categories like tractors and air conditioners are hovering around 2007 levels with recent growth simply offsetting large negative growth last year. Chinese exports remain subdued so most of this output is either going to local buyers or is building up in warehouses.
If the government numbers are to be believed, production is up – making it about the only place in the world where ‘tightness’ in labor and/or raw materials might be legitimate. Additionally, there has been record growth in money supply through bank lending earlier this year. Lastly, China with its currency pegged to the U.S. dollar has effectively imported America’s loose monetary policy. If there is any place in the world with hyperinflationary risk, it’s China. The Chinese government does have a way to deal with it through strengthening its currency but so far it appears loath to embrace this path.
In the end interest rate curves are a reflection of expectations rather than actual inflation or growth. As with last June, expectations can come and they can go. It is only profitable to buy into them if what they are based on comes to pass. Yet if there are enough traders with the same expectations, these expectations can drive markets for many months or quarters without the true event coming to pass. One just needs to look at oil prices despite being awash in extra supply. Eventually, either expectations are realized or markets correct.
So what is the point of it all? There are legitimate concerns about inflation in the United States and elsewhere. Yet, if inflation is primarily by driven tightness in labor markets and/or materials, Germany will likely be ahead of the U.S. or the U.K. when it happens. On the other hand, if it is money printing and runaway government budgets that drive inflation, it should be Japan that faces the real test first. Yet neither of these is priced into the markets.
We all assume price is a reflection of the most likely scenario. Maybe it is simply a reflection of the most crowded trade. The most likely scenario is inflationary pressures in China but without a solid government bond market and a free floating currency this is a much more difficult trade. It is much easier to sell the dollar, buy gold and oil, and report it as the likelihood of runaway inflation in the U.S. Such inflation is possible but more likely to appear elsewhere first.
Disclosure: No Positions
