My F&M

Notes on Policy Developments and Inflation Risks

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A world addicted to easy money policies got a bit of a scare last month when Ben Bernanke, head of The Federal Reserve, hinted that the day may be approaching when The Fed may scale back its massive asset purchases, currently running at a rate of $1 Trillion per year (yes, that's trillion with a "T").  Japan's stock market in particular swooned by more than 7% in response.

Meanwhile, there have also been meaningful recent developments in China, Japan, and Europe.  In April, Japan's central bank announced plans to double its monetary base by 2014 and, in an important twist, its asset purchase program includes not only government bonds, but also stocks!  So as the Fed seeks an opportunity to wind down quantitative easing, the Bank of Japan is significantly ramping it up.

Meanwhile, China though experiencing disappointing growth, recently announced that additional stimulus is unlikely.  With bubble-like conditions in its property market and a banking system lacking the discipline of a profit motive, any slowdown in China certainly has the potential to spiral into something worse.

And late last month in a surprise move, Germany announced it will make low interest business development loans to Southern European companies (first in Spain, soon in Portugal and Greece).  While not large in the scheme of things, many see this as a very important policy shift for Germany as these loans have no austerity requirements.

In 2008-2009, economic conditions were challenging (to say the least), but with all major central banks around the globe easing in a coordinated manner, at least large currency shifts were not a part of the mix.  Now, with increasingly different monetary policies globally (and to a lesser degree, fiscal policies), global currency markets run the risk of significant disruptions.  Currency exchange rates matter because it is through this mechanism that inflation can be “imported” or “exported” around the globe. 

For example, a devalued yen allows Japanese manufacturers to sell their goods in the US at lower prices (in dollars), lowering those prices here and putting downward pressure on the prices of similar goods here.  This would be an example of “exporting deflation”.  Meanwhile, the Japanese consumer would face higher prices for goods imported from here – “imported inflation”. 

The key is that greater volatility in exchange rates likely means that inflation, which has been both stable and low in recent years, has much greater potential to be more volatile going forward. 

Note that more volatile inflation doesn’t only mean potentially higher inflation; it can also mean potentially lower inflation (at least, in the short run).  We have added to small gold positions in portfolios in recent months as a hedge against likely higher inflation in the long run.  But more recent weakness in the dollar price of gold may indicate a greater possibility of lower inflation near term.  For example, if the Fed does scale back its monetary stimulus at a time when the Japanese central bank is expanding its stimulus, Japan may “import” some inflation from us for a time as we “import” some deflation from them!

None of this is a reason for any dramatic portfolio changes.  It’s just a new and potentially important developing cross-current that may make changes in the rate of inflation (up or down) larger and therefore more important to financial markets.  As such, if anything, it likely enhances risks of an overdue market correction.  As portfolios are positioned with a cautious tilt, a correction could bring a period when caution brings a return benefit rather than simply a cost.