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Developing the Best Plan to Bet on Inflation

Thursday, 15 Apr 2010 06:25 PM

By Hans Parisis

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We have had a couple of recent interesting remarks about inflation.

“Any decision that is made by the central bank will aim to keep inflation stable, stabilize prices, and inflation within its target,” Brazilian Central Bank President Henrique Meirelles said.

Putting that into the Brazilian context, during the 12 months through March, its IPCA inflation reached 5.17 percent and continued rising, while their central bank’s year-end target for IPCA inflation is set at 4.5 percent.

No doubt, the central bank will apply higher interest rates as its first line of defense against rising inflation while it also advises more openness of the Brazilian markets to foreign goods. That said, the central bank itself sees the country's reference Selic interest rate rising to as high as 11.25 percent by year end, compared to 8.75 percent where it stands now.

Tuesday, the yield on the interest rate future contract due January 2011, the most traded on Sao Paulo’s BM&F exchange, jumped 7 basis points to a 10-month intraday high of 10.59 percent.

No “Western style” quantitative easing over there.

Speaking in Morgantown, W.Va., Federal Reserve Bank of Richmond president Jeffrey M. Lacker said: “Inflation remains benign … we will need to be careful as the expansion strengthens to keep inflation and inflation expectations in check … To keep inflation contained, we will need to be careful about when and how to withdraw the considerable monetary policy stimulus now in place … this time the Fed will have two monetary policy instruments at its disposal, not just one. The Fed traditionally has targeted the overnight federal funds rate” and “two mechanisms by which we could drain bank reserves ─ reverse repurchase agreements and a term deposit facility. Both would amount to issuing Federal Reserve Bank debt to absorb reserves … Such an approach would move us more rapidly to a ‘Treasuries-only’ portfolio, and thus more rapidly reduce the extent to which our asset holdings are distorting the allocation of credit.”

He also said that “looking beyond the near-term challenges for monetary policy, however, our economy does face several significant challenges over the longer term. One of these is the path of future federal budget deficits implied by current and planned fiscal policies. The government’s debt cannot grow indefinitely at a rate much faster than the economy itself grows, so ultimately, something has got to change ─ either taxes are raised, spending is reduced, or the real value of the debt is eroded through an increase in inflation, an outcome the Federal Reserve is committed to preventing.”

In my opinion, central banks like the Federal Reserve know very well what they need to do to unwind their overly inflated balance sheets in a timely fashion, once credit conditions normalize, in order to control inflation.

However, if they have their independence limited by political institutions as is still the case in “some” important developing economies, this could certainly raise the inflation risk in the related countries.

The inflated balance sheets of the Western central banks, like the Fed, can affect inflation depending on the way in which the money moves out of the Fed’s balance sheet and into the broader economy, which, by the way, isn’t occurring yet.

Once it starts moving into the broader economy, there’s still about a two- to three-year interval between expanded money supply and inflation. So far, these overly inflated balance sheets in the U.S., but also in the U.K. and the EU, have only truncated the deflation risk.

Nevertheless, investors should keep in mind that in the longer term, the unwinding of these inflated central bank balance sheets pose a substantial risk for inflation with or without political interference.

Meanwhile, developed economies have not fully healed from the recession and consumers are not ready yet to stand on their own two feet.

I think that in the developed economies, any meaningful inflation should still be a couple of years away; this is not the case and completely the opposite in the developing economies.

In my opinion, those investors who would like to bet on inflation, I think they’ll have a higher probability of success in the developing economies within a 2-year horizon than in the developed economies, which still face a near-term risk of tiptoeing into deflation territory.

In the longer term, we will have higher and more volatile inflation than was typical in the past everywhere.

At that time, “liquid tangibles” will be good to have.


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