Some of Canada’s leading hedge fund professionals think inflation is on the rise.
That was the vote at AIMA-Canada’s eighth annual parliamentary-style debate, which tackled whether inflation or deflation lies ahead.
Arguing for the inflation side, Hubert Marleau, co-founder of Palos Management in Montreal, pointed to the U.S., where the consumer price index is up 3% and producer prices are up 6%, and both trends he says, have been accelerating for six months. More worrisome, he finds, is that import prices have jumped 10%.
“There is no doubt in my mind that we are entering an inflationary era,.” he adds, made worse by monetary policy.
The monetary base is three times larger than it was in 2008, before the financial crisis. Money supply is increasing at twice the rate of GDP growth. “The difference has to go somewhere,” he says.
At the end of the day,” he says, “inflation is about basically two things. It’s whenever you have a monetary policy and it is easing when it ought to be tight. In the United States, you have a monetary policy that is easing when it ought to be tight.
He cites three examples. First the misery index, which combines unemployment rates and inflation in a single number, is seeing inflation take up a greater share – now 30% of the index.
To that he adds the Taylor rule, which attempts to derive a Federal Funds rate for a given level of economic capacity. Marleau says the rule assumes a natural unemployment rate of 5.5%. He thinks the actual natural rate is higher, at 7%, thanks to structural impediments in the U.S. economy, such as lack of labour mobility and skills deficits as well as a rise in the informal sector – or more properly, people doing it themselves rather than relying on monetized goods and services. As he notes, he booked his own ticket to fly to Toronto for the debate rather than relying, as he would have in the past, on a travel agent.
By that estimate, Marleau thinks the Fed Funds rate should be at 2%, not its current 0% to 0.25% range.
Finally, he thinks monetary policy, which in the U.S. attempts to optimize inflation and unemployment, also needs to consider the balance of payments – how a country pays for its imports. Given the inflation in import prices, he thinks the U.S. Fed should be tightening not easing. The alternative, on the balance of payments side, is a devalued currency, which itself, he argues, would be inflationary, pointing to the post-Second World War travails of the pound sterling and the French franc.
The second aspect to inflation, he adds, is that the Fed has an in-built inflationary bias because of the size of the Federal debt. “There is no way that the Federal Reserve nor the U.S. Treasury is going to accept defaulting. The only way to get rid of defaulting is either to grow your economy, which can’t grow because the labour productivity is not there,” says Marleau, “or to inflate.”
In the current context, inflation is is the easiest, most politically acceptable path, he argues. “You cannot have it any other way. Otherwise you’re going to have a revolt on the street.”
But Derek Holt, vice-president at Scotia Capital Economics in Toronto, reads the tea leaves differently.
“I don’t view what the Fed is doing now as being grossly inflationary.” Money supply, he says, is not out of hand.
While banks, as Marleau suggests, may now be in a position to lend, the demand just isn’t there. There is little new private credit creation, Holt says, except for student loans. “That says I’m giving up, I’m going to hide for a while and repair my skill set,” Holt explains..
More importantly, international debt problems are dicey. When the ECB debt patch comes off in 2013, Greece will have to return to private markets to borrow – and they may not grant the same easy terms as before. In any case, repaying sovereign debt – or simply financing it – will create a fiscal drag on European countries – and the United States – all of whom will face the difficult decisions Canada made in the mid-1990s: cut program spending, raises taxes, or both.
Neither decision is likely to backstop growth. The likely result will be a 2% or 2.5% hit to GDP, which the private sector will have to make up.
For inflation to take purchase, he says, there would have to be a “colossal policy error” on the part of the central banks. “It’s possible that central banks around the world react to high commodity prices by tightening monetary policy, which I would argue, in the longer-run is the inappropriate policy response. because it’s reacting to a relative price surge that is probably going to reduce purchasing power in many of these countries and is going to be fairly disinflationary.”
If interest rates are raised to curb commodity inflation, he thinks, the effect will be to “sap purchasing power in just about every other sector of the economy.”
As for the emerging economies, which are setting the pricing of commodities, “they have unhitched their wagons from developed economies,” encouraging their own domestic markets and trading more and more amongst themselves. They will take up global commodities demand. That creates a policy conundrum. In developed economies, “We’re only going to pay more over time for gasoline and food, which might sound inflationary, but if you’re limited in terms of your domestic opportunities, wage opportunities and credit access,” he says, “then it’s probably going to be deflationary or disinflationary.”
For both Marleau and Holt, commodity prices seem to hold the key to inflation or deflation. Marleau thinks they will spur higher prices elsewhere. Holt thinks they will undermine purchasing power as a whole. The AIMA-Canada audience thinks the former is more likely.