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The Wrong Kind Of Inflation

Written by Paul Amery

  
January 05, 2011 00:00 (CET)

If Britain’s trains are notorious for halting after meeting the wrong type of snow or the wrong type of leaves, politicians and central bankers are now faced with the aftermath of having created the wrong type of inflation.

According to this morning’s Financial Times, global food prices hit a record high last month, surpassing the levels seen in 2007/08. Oil prices have jumped sharply since the end of last summer, anticipating and then continuing to react to the resumption of the Federal Reserve’s quantitative easing (QE) programme. Industrial metals prices are also surging: the price of copper has increased by nearly 50% after six consecutive months of gains, topped by December’s 17% jump.

This rapid increase in the prices of key raw materials is having a two-fold effect: it’s causing a dramatic jump in the cost of living for consumers worldwide, with all the associated risks of social and political unrest; and, at the same time, it’s increasing the chances of the same kind of demand shock we witnessed when oil prices spiked in 2008, which then contributed to the autumn’s financial crisis.

However, while policymakers’ near-zero interest rates and bond market interventions are causing destabilising hot money flows into commodities and emerging markets, they are signally failing to have any effect on broader, long-term inflation expectations. Getting such longer-term expectations to rise and thereby achieving a reduction in the real debt burden inherited from the credit bubble is the key (if often unstated) objective of QE.

The table below shows the change in break-even inflation rates for a series of inflation-linked government bond issues between the end of 2009 and December 31 2010. To recap, the break-even rate for a given inflation-linked bond is the average inflation rate over the life of the bond required to produce the same return as is currently being offered by a fixed-rate bond.  As such, the break-even rate is a useful measure of the market’s built-in inflation assumptions, particularly over the long term. Data are taken from the FT website.

Inflation-Linked Bond

Break-even Inflation Rate 31/12/2009 (%)

Break-even Inflation Rate 31/12/2010 (%)

Change (b.p.)

Canada 4.25% 2021

2.65

2.40

-25

France 2.25% 2020

1.42

1.90

+48

UK 2.5% 2024

3.38

3.22

-16

UK 2% 2035

3.75

3.60

-15

US 3.625% 2028

2.51

2.40

-11

Of the countries in the table, only in France have ten-year inflation expectations risen over the last twelve months, with anticipated inflation in the US and the UK actually declining. And that’s despite all last two years’ predictions of runaway price increases, with the resulting large inflows into inflation-linked bond ETFs, and despite all the noise over quantitative easing.

Real yields on longer-dated inflation-linked bonds, meanwhile, have slipped back across the board over the year. You can interpret low real yields in different ways, but one way of looking at the phenomenon is that it reflects lower anticipated long-term growth rates, and a lower expected rate of return on investments of all types. That doesn’t quite chime with the equity markets’ current mood.

Inflation-Linked Bond

Real Yield 31/12/2009 (%)

Real Yield 31/12/2010 (%)

Change (b.p.)

Canada 4.25% 2021

1.35

0.93

-42

France 2.25% 2020

1.42

1.34

-8

UK 2.5% 2024

1.07

0.65

-42

UK 2% 2035

0.72

0.60

-12

US 3.625% 2028

2.07

1.68

-39

Generating price increases in exactly the wrong areas has placed politicians and central bankers in a nasty bind. Given commodity inflation, there’s limited, if any opportunity to increase the scope and scale of QE programmes any further. But should higher oil and raw materials costs cause another recession, all price expectations could well then take a dive, with commodities entering another bear market and broader inflation indices threatening a descent into outright negative territory: deflation, in other words.

 

 

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The views expressed by those blogging are for informational purposes only and should not be construed as a recommendation for any security.
 

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