Inflation Has Been Rising

In this article, I will discuss the global rise of inflation. Normally the level of inflation we’ve see globally wouldn’t be a big deal because it is still relatively low. While I think inflation targeting is a bad policy for central bankers to pursue, I would never go as far as saying if they achieve their goal there will massive problems. Wanting to achieve 2% inflation is a silly goal because inflation is constantly vacillating, but having this level of inflation isn’t necessarily a disaster. The reason why inflation increases are bad in this current scenario is because the central banks have been orchestrating extraordinary monetary policies which will be forced to stop.

Because central bankers view inflation as synonymous with growth, they want it. Inflation to them signals strong demand. However, if you’re devaluing the currency to increase inflation are you really creating strong demand? Regardless of the rationalization of these policies, it’s important to understand the negative effects of inflation. Inflation hurts the consumer and it makes it more expensive for governments to finance their deficits. The quantitative easing programs are supposed to help stabilize the economy. They are deemed to be inflationary. However, instead of rolling them back, governments are going to need them more than ever to avoid deficits running out of control. If QE is forced to resume, it will look even more like debt monetization than before.

The ECB is currently buying $80 billion in bonds per month. It will taper this buying to $60 billion per month from April to December. In the summer, when the decision is debated, the options will to be to do another taper or end the program completely. The reason why I mentioned the current program is because European bonds had the worst January on record. The chart below shows the historic selling in European bonds. That’s quite an accomplishment with the ECB buying $80 billion. Imagine how bad this would have been if the ECB didn’t have the bond buying program. That’s certainly a possibility starting in January 2018. Judging from the rhetoric out of policymakers, they would view this bond selling and increased CPI, which has reached 1.8% in January, as evidence QE was a success. With the extraordinary debt to GDP levels of southern European nations, higher government bond yields start to cause problems very quickly.

BondSelloff

The chart below shows this inflation increase hasn’t been limited to Europe. Inflation spiking means central banks are losing their power. The BOJ may have to slow its ETF buying and the US may have to raise rates faster than one quarter point per year. As you can see, if the inflation surprise index moves slightly higher, it will reach the second highest price it has reached in the past 18 years. The PMI manufacturing price index, which I explained yesterday, showed similar results.

moresurprises

As you can see from the chart below, the Japanese 10-year bond yield is hitting 52-week highs. While I wouldn’t say inflation is going gangbusters, it is impressive how this trend is effecting all the major economies. I mentioned that the BOJ may be forced to slow its ETF buying, but the question remains if the action is irreversible. The selling pressure on stocks by the BOJ would force a major correction. It is likely stuck with what it has bought.

japangovbond

The chart below shows the historical CPI. Low inflation in the past three years has allowed the Fed to get away with low interest rates without any consequences. Inflation is now getting back to the level it was at in 2013. We’ll see if it starts to break out of this range when the next CPI report comes out on February 15th. The Fed targets 2% inflation, but seems to be fine with it going slightly higher. I think the CPI hitting 2.5% would make the Fed quicken rate hikes faster than one per year.

CPI12month

Let’s now quickly look at how assets have reacted to increased inflation. Another way of looking at this could be, the way these assets are performing proves there has been increased inflation. The chart below shows the 10-year bond yield. It’s up about 16 basis points since January 17th and is nearing its 52-week high of 2.6394. Gold is having a great year as its up 5.13%. Bitcoin is also having an amazing year after it had quick spurt of volatility. It is up 5.6% year to date. I will keep watching to see how these assets react. If yields are increasing and gold and bitcoin are moving higher, it’s a signal inflation is strengthening.

10yearbondus

As I mentioned, the inflation rate increasing hurts consumers. Their disposable income doesn’t buy as much as it previously did. The chart below shows the personal savings rate of Americans is declining. Consumers are dipping into what would be their savings to spend money. This spending hasn’t resulted in increased retail spending as brick and mortar retailers have had a terrible holiday season. If the consumers are decreasing savings just to maintain their spending, this is a bad sign.

fredpersonalsavings

As a counterpoint to the great ADP report which I discussed previously, the chart below shows the employment cost index. The cost inflation has not come close to recovering from the recession. Even though the jobs market is healthy, it clearly hasn’t reached full-employment because at that point, wages start rising at an accelerated rate. It’s questionable if wages will ever rise to the previous heights given the recovery is already 8 years old. Trump’s new economic message has the goal of increasing these wages. We’ll know whether that worked out sometime in 2018.

employmentcostindex

Conclusion

Inflation has continued its trend higher. I expect the CPI to show a moderate increase when it is reported on February 15th. What I’m interested in is the Fed’s reaction to the inflation. The ECB has a more stringent mandate to keep inflation below 2% and it is ignoring the 1.8% inflation, so I wouldn’t be surprised to see the Fed to do the same. The point of this article was to express concern about what would happen if it continued on this path higher and central banks could no longer ignore it.

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