“Inflation is taxation without legislation”
Milton Friedman (1912 – 2006) American economist
The stealth bomber, an advanced strategic aircraft for the U.S. air force, was built from ground up to evade radar detection1. It achieves this through a combination of design, advanced composite materials and special paint.
By being significantly less visible, the stealth bomber can more easily penetrate dense anti-aircraft defenses, raising the chances of a successful bombing mission. The element of surprise remains essential to modern warfare.
The economy, in the more recent past, has also been experiencing a “stealth bomber” like moment of its own. The current economic cycle is somewhat odd: you have large economies such as the U.S. and Europe that have maintained extremely loose monetary policies over an extended period, and yet an almost total absence of inflation. So what gives?
What if inflation is actually surging and the traditional methods of measuring it are just not capable of capturing the rise2. Wouldn’t that be the equivalent of a surprise stealth bomber strike? That depends on what happens next. If the authorities are underestimating the true extent of inflation and this cumulates over the long term, we might reach a point where it becomes too late to do something about it.
The evidence on stealth inflation is at best inconclusive, but there are plenty of signs of anomalies in the greater economy that do point towards a “stealthy” form of inflation picking up. The sharp rise in asset prices over the last year and half is a case in point. Equity markets have been surging, but so have such things as the auction prices for select art or real estate in prime locations across the globe. These are pockets of bubbles that don’t appear in any of the CPI measures.
There is also the case of currencies. These have remained relatively stable from the perspective of purchasing power and fluctuations in exchange rates over the last couple of years. That perception becomes grossly misleading when you start comparing paper money to gold (arguably the most consistent and objective measure of value in existence). The value of gold has been rising for most of a decade and half. In the meantime, the world’s major currencies have been depreciating against gold3.
One may ponder at the long-term implications of a stealthy inflation buildup. For monetary authorities, it is akin to navigating a ship with a faulty compass: the path taken could be the wrong one. If governments are relying on the same measures as the public, the policies that are being enacted could be causing long-term damage.
We may already be experiencing some of the effects of this surge in unaccounted for inflation. There is more than just anecdotal evidence that it may be widening the social inequality gap4. Asset bubbles tend to benefit the owners of those assets. If everything else remains constant, or worse, loses value, it will widen the disparity between the “haves” and the “have-nots”.
It could also be that this “stealthy” build up is a time bomb that will culminate into the next major economic crisis. If the value of paper money is truly depreciating, and the difference between the “perceived” value and its “real” value continues to widen, people will eventually become aware. That would be a “risk on” moment, which could trigger a shift from “paper money” to tangible assets. Considering that the “intrinsic” value of a firm’s share price is obtained by calculating the present value of future revenue streams, a depreciation in the purchasing power or value of the currency may also trigger a selloff in stocks.
What is certain is that the economic realities on the ground today are very different from those of the past. As such, policies, but more importantly, economic measures need to be carefully revised to reflect and adapt to these “changes”. Not doing so is just inviting trouble ahead.
Where Do We Go From Here?
Inflation could very well be understated due to the way in which it is being measured. This is worrisome, especially in the U.S. and U.K. where the latest figures are indicating a marked pickup in the inflation rate5. Countering the aggressively loose monetary policy and possibly flawed inflation figures are powerful longer-term secular headwinds that represent a hazard in the opposite direction. In Europe a threat of deflation hovers as a result of heavy-handed austerity measures6 whilst the U.S. has been somewhat spared of this threat, thanks to more
accommodative policies.
The headwinds behind the protracted sluggish growth environment are in part a result of a change in demographics. With an aging population sweeping across most developed markets, growth and productivity have been losing momentum. The “baby boom” cohort is right at the stage of a massive influx into retirement, which means that those that are exiting the labor force are expected to expand significantly in coming years7.
The same dynamics are also starting to affect the emerging markets that have lost their growth luster over the more recent past. Aging populations combined with the wealth effect of industrialization are powerful decelerators of growth, which is why China and other large emerging market economies are now struggling with what is clearly a transition phase towards a slower equilibrium.
The demographic effect is being further compounded by a continued buildup in debt, most notably in Europe and the U.S. where the monetary authorities are still attempting to revive their respective economies. Short of outright defaulting on their debt8 or through a massive devaluation of the currency, governments have few options at their disposal to keep debt levels manageable. One such recourse involves a gradual tapering of the issuance on new debt (which is exactly what the U.S. has embarked on).
There is growing pressure to “deleverage” on debt, both at the government and corporate levels, which could add upside pressure on bond yields. The problem with this scenario, of course, is the spillover effect it would have on businesses and mortgages. Higher yields will be sapping growth at a critical juncture for economies that are still being sustained through monetary interventions.
Central banks are treading a fine line between having to preemptively strike against crisis forming bubbles and sacrificing growth. Monetary policy is notorious for its bluntness, the equivalent of military carpet bombings, which is why there is an increasing move towards a targeted “macroprudential” approach9 to get the job done.
Other inflation challenges also lie ahead, and include a recent surge in oil prices. The geopolitical tensions that have been culminating and spreading across the Middle East have been fueling this rise. Syrian, Libyan and now Iraqi oil exports are being increasingly compromised. The rising conflict between Ukrainians and separatists are not helping either. With so many conflict zones to deal with, the possibility of things spiraling out of control is on the rise.
Oil prices are capturing these anxieties. The problem with higher oil prices is that they act as a sort of tax on the economy that can dampen a recovery. More serious is the duration or length of time that significantly elevated prices persist. The longer they drag on, the greater the damage is likely to be. These are serious concerns, posing formidable challenges to monetary authorities across the globe. A sharp rise in energy prices in a weak recovery environment, which is exactly what the Eurozone is facing at the moment, is a highly toxic combination which can lead to stagflation.
The present disequilibrium in markets is clearly not as overt and widespread as with the housing bubble in the first half of the previous decade. There are pockets of bubble formations across the globe (equity markets in the U.S., Europe and Japan, housing in the U.K.) that appear to be manageable for the time being. But what if we are not seeing the complete picture, what if we are being misled? As with the stealth bomber analogy, by the time we gain awareness, it may really be too late to do much about it.
Altug Ulkumen, CFA
Independent Contributor
aulkumen@gmail.com
1 It should be noted that stealth technology does not entirely evade radar detection. Depending on the type of radar being used and the altitude and speed of the aircraft, the degree of cloaking can vary significantly. Still, compared to conventional design, the results can be dramatic.
2 Official measures of inflation such as the Consumer Price Index don’t capture changes in asset prices or real estate. This can be considered a major flaw given the importance of these factors in the economy.
3 Commodities, such as oil have also been appreciating over time, not because they are becoming more valuable, but more because of weakening purchasing power. This is very apparent when you compare the oil purchasing power of gold (which has remained steady) and that of the U.S. Dollar (which has been experiencing steady erosion).
4 Capital in the Twenty-First Century, Thomas Piketty and Arthur Goldhammer.
5 As measured in its understated form. Policy makers are likely making matters worse by concentrating on core inflation, a subset of headline inflation created to reduce the volatility from energy and food components.
6 The latest economic figures for the Eurozone point towards a slowdown across the block with a possible contraction for France.
7 The effect has been mitigated by the market crisis of 2007 and the ensuing economic slump. A large segment of the pre-bretirement population has a large chunk of their “nest eggs” eroded by the market corrections in the earlier years, forcing them to postpone retirement for some time to come.
8 Greece’s infamous “haircuts” following the sovereign debt crisis of 2010 are an example of this.
9 An approach that specifically targets bubble-prone sectors by regulating them. Examples in the banking sector include restrictions on lending or changes in reserve requirements.
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