Monday, April 12, 2010

BIS: All roads lead to inflation

Last week Stephen G Cecchetti (Head of the BIS Monetary and Economic Department), M S Mohanty (Head of BIS Monetary and Economic Department) and Fabrizio Zampolli (Senior Economist) of the Bank for International Settlements, released a working paper entitled The future of public debt: prospects and implications.

Structural deficits overwhelm the developed world
The paper paints a terrifying prospect for the inhabitants of most of the developed world. The chart below shows the projected debt to GDP ratios of Europe, Japan and the United States for the next 30 years. The red dotted line depicts the baseline scenario, which assumes that assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 OECD projected levels. The green line assumes budget cuts of 1% of GDP for five years starting in 2012. The blue line assumes deeper cuts to entitlement programs, e.g. pension benefits, etc.

(click for a bigger picture)

The report states:

Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery.

Under the baseline scenario, deficits spiral out of control for every western industrialized country under study. What is more depressing about this study is that, regardless of the level of budget cuts (with or without cuts to promises made about entitlement programs), debt to GDP continue to skyrocket for the major industrialized countries of Japan, UK and US.

Inflation is on the way
The authors then conclude that all roads seem to lead to inflation and a tight monetary policy cannot prevent its resurgence [emphasis mine]:

When the public reaches its limit and is no longer willing to hold public debt, the government would have to resort to monetisation. The result, consistent with the quantity theory of money, is inflation. And anticipation that this will happen may also lead to an increase in inflation today as investors reassess the risk from holding money and government bonds. In such an environment, fighting rising inflation by tightening monetary policy would not work, as an increase in interest rates would lead to higher interest payments on public debt, leading to higher debt, bringing the likely time of monetisation even closer.

Thus, in the absence of fiscal tightening, monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank.

In other words, a Volcker style approach of tight monetary policy in order to wring inflationary expectations out of the system may be futile. Inflation is ultimately a fiscal phenomenon. What's more, bond market vigilantes won't solve the problem in time [emphasis mine]:

[B]ond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly ageing populations, for many countries the path of pre-crisis future revenues was insufficient to finance promised expenditure.

You can't grow your way out
The standard solution for believers of the free market is that organic growth, i.e. economic growth not from government stimulus, will eventually happen. We can grow our way out of trouble. The report believes that these structual deficits are so overwhelming that you can't:

We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.

How to beat the American military without firing a shot
Fiscal deficits do matter and interest on debt can overwhelm spending priorities. Long-time analyst Richard Russell, publisher of the Dow Theory Letters since 1958, wrote the following words about a year ago:

The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about at 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let's say that by some miracle the interest on the national debt in 10 years will still be 3.04%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof.

If the BIS projections are correct and debt skyrockets, a 3% interest rate would be absurdly low. To put Russell’s admittedly optimistic projection of $618 billion interest bill into perspective, that’s roughly the same order of magnitude as the 2010 total reported military budget of $664 billion. In fact, Paul Krugman characterized the US government as an insurance company (i.e. entitlement programs) with an army:

The basic picture of the federal government you should have in mind is that it’s essentially a huge insurance company with an army; Social Security, Medicare, Medicaid — all of which spend the great bulk of their funds on making payments, not on administration — plus defense are the big items.
Bill Gross of PIMCO also came to a similar conclusion about the trajectory of the US fiscal position:

As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

Is it time to “buy” inflation?
The authors of the BIS working paper believes that all roads lead to inflation. I concur with that view and inflation hedge vehicles such as hard assets, commodities and shares of commodity producers have their place in a portfolio. However, I have also expressed the belief that any commodity bull is likely to experience a high degree of volatility.

Here is the dilemma. Global economies are currently mired in a fragile slow-growth environment, but, as inflation could break out at any time. Investment hedges that perform well in a runaway inflationary environment will do poorly in a recessionary period and vice versa. You can get the picture right and get hurt really badly in the interim.

Consider the chart below showing the monthly price of gold during the 1970’s. Even though the yellow metal rocketed from $35 in the early 1970's to $850 in January 1980, investors would have suffered a correction of 43% - and that’s based on monthly prices. The peak-to trough correction in gold would have been even more using daily pricing.

The world faces a high degree of uncertainty about policy direction, which would result in gut-wrenching intermediate term market volatility. Consequently, I am operating with a base case scenario of several episodes of volatility with draw-downs of 50% or more in a multi-decade long secular commodity bull. Investors who don’t have that level of tolerance for those kinds of losses need the necessary tools to be able to navigate these ups and downs.


MCKibbinUSA said...

My technical analysis regarding future inflation is much more tame than that expressed in your link. Although fundamentals are not considered in my analysis, the technicals point toward inflation (as proxied by gold prices) to remain near the risk free rate. More at:

Thanks for the opportunity to comment...

David Wozney said...

If the stated value, of “Federal” Reserve notes, declines enough with respect to copper and nickel, the 1946-2009 nickels, composed of cupronickel alloy, could get somewhat rare in mass circulation.

The April 9th metal value of these nickels is “$0.0609425” or 121.88% of face value, according to the “United States Circulating Coinage Intrinsic Value Table” available at