PEAK VALUES
RESEARCH
Inflation in Developed Economies
PEAK VALUES
Inflation in Developed Economies
Where is Expected Inflation in Developed Economies?
In general, the price of goods and services changes over time. Generally it’s increasing. This is our
concept of inflation. A country generally measures inflation by selecting a “basket of goods and services”
that best represents consumption by its residents and periodically documenting the price of that basket.
Governments must occasionally update the contents of the basket, as consumerism evolves. In 2013 we
are not buying the same things our grandparents bought in 1940. In addition, governments may need to
update the basket based on a changing population base. Nations each select the goods and services for
their own baskets; consider how different China’s basket is from that of the United States.
People are often surprised when they see official government inflation figures. They are experiencing
inflation, or rising prices, quite differently. For instance, Swiss residents are astonished to hear that
Switzerland is currently experiencing low inflation. They are living with significantly rising rents,
travel expenses, and healthcare costs. This disparity can be the result of anomalies in that basket of
goods and services, or of defective government projections, or even of outright corruption and political
manipulation.
Argentina’s national statistics bureau, Instituto Nacional de Estadísticas (Indec), announced on August
15th of this year that the country’s inflation rate for the month of July was 0.9 percent, bringing the
official annualized rate—the number anticipated for the full year—to 11.2 percent. This is well below
estimates and reports from private economists and political opposition figures who say July’s rate of
inflation was closer to 2.55 percent, and the annual rate of inflation is 24.9 percent. The government is
reacting to such announcements by jailing independent economists.
On the other hand, Japan has been suffering with deflation, a downward trend in the cost of its basket of
goods, despite repeated government predictions of a turnaround. After 12 straight months of deflation, in
July of this year, inflation reached an annual high of 0.91 percent, which can only be seen as hopeful. The
political interest is clear: politicians are motivated to demonstrate that they are able to control inflation
and so promote a nation’s wealth. For a developed economy such as Japan, inflation is a political target.
2
PEAK VALUES
Inflation in Developed Economies
Money (and What Is Behind It)
It is critical to understand what money represents and how it is backed. Central banks provide money—a
piece of paper, whose value is covered by securities, foreign exchange or gold. Under some circumstances,
banks guarantee to exchange the paper money for something of intrinsic value. For instance, in the
United States, on 31 January, 1934, 100 US dollars (USD) could be exchanged for 88.8671 grams of gold.
These days, central banks frequently buy government debt or currencies instead of gold. This is evident
in the quantitative easing (QE) programmes, where the United States Federal Reserve (the Fed), is
buying government debt in an unprecedented way.
It is worthwhile to compare the quality of the assets of the Swiss National Bank (SNB) and those
of the Fed. The latter has bought billions of dollars worth of low-quality fixed-income products and
subsequently released a large amount of money. The SNB has a substantially better portfolio of assets.
If many of the Fed’s bonds defaulted, the USD would lose value against the Swiss franc.
Two key elements must be considered here: First, gold plays a minor role in the portfolio of most
central banks and cannot in reality be considered as a natural hedge (see also my article regarding gold).
Second, the way a central bank manages its reserves—the quality of the bonds and currencies bought—
directly influences the price stability of a country.
3
PEAK VALUES
Inflation in Developed Economies
The Role of Central Banks in Managing Inflation
Stabilizing inflation is one of the most important tasks of a central bank. By acting on the money supply—
providing financial institutions such as commercial banks with liquidity—the central bank targets price
levels and ultimately the labour market. These latter institutions then use the money to lend for industrial
projects or mortgages, which in turn create jobs.
If a central bank is not providing necessary liquidity the effect can be disastrous. Little credit is provided
and investment becomes almost non-existent. Production ceases. Workers are laid off. The supply of
goods and services exceeds demand and prices start to deteriorate. John Maynard Keynes, the British
economist, urged the government authorities to provide liquidity and people to spend during the interwar years. This was contra-intuitive: spending during rainy days is not an obvious action, but according
to Keynesian economics, state intervention was necessary to moderate “boom and bust” cycles of
economic activity.
What happens if the real economy is flooded with money that is not properly backed? (We’ll return in a
moment to this term, “the real economy.”) As the money is transferred to the real economy, the consumer
or investor begins to ask him/herself how much value the money represents. This is the subjective
component of money’s value as opposed to its intrinsic value as backed by gold or other securities.
Ultimately if confidence is lost in money, goods and services become more expensive. Bread today
could cost USD 1 and rise tomorrow to USD 1.50. This means inflation of 50 %!
A good example of money not properly backed is the les assignats de la Révolution française (assignat),
issued from 1789–96 during the French revolution: At the very beginning of the revolution, this money
was secured by the church’s confiscated real estate. Unfortunately, the assignat, originally intended to
perform like a bond, began to be used and accepted as currency. The government failed to control the
amount of assignats printed, and it quickly began to devalue. By the time Napoleon introduced the franc
in 1803, the assignat was worthless.
Another example of improperly backed money was the German Papiermark of the Weimar Republic in
the 1920s. Due to Germany’s decisions about financing World War I and the crippling situation imposed
on the country to pay reparations following its loss of the war, inflation rose rapidly. At the end of 1919,
more than 6.7 paper Marks were required to buy one USD. By November 1923, the American dollar was
worth 4,210,500,000,000 German marks.
In summary, a central bank should lend money to the economy but retrieve it quickly when the economy
is up and running in order to avoid the negative effects of hyperinflation, especially if that money is not
sufficiently backed.
4
PEAK VALUES
Inflation in Developed Economies
What’s Happening Today?
It is impressive how central banks have extended their balance sheets in order to stimulate the economy.
However, with some notable exceptions such as the US where the stimulus seems to be more effective,
many economies are still in recession and we are simply not seeing evidence of inflation. This is quite
strange.
To explain this we have to ask ourselves where the money is going. A key element is that the created
money must be injected in the real economy. This means that banks must lend outside the financial
sector. The US, by restructuring its banking sector, saw the economy start to improve as some part
of the money created by the Fed was lent by banks to fund the recovery programs that created goods,
services, and therefore jobs. The importance of lending money—supplying credit even under very
simple conditions—can create impressive results such as those seen in emerging markets like India with
micro-credit provided by the private sector or Brazil and Bangladesh, where very small loans were made
available to the poorest sectors of society to start small businesses.
But why aren’t we seeing inflation in many developed economies? The short answer is that the created
money has not entered the real economy. One way to understand this is to equate the money exchanged
in the economy with money around and how fast people are shifting it. This should make having a lot
of money but not using it equal to having little money that is often used. Roughly speaking we have:
Volume needed = Money circulating x Velocity of the money circulating
Volume needed is the amount of money needed to buy goods. Buying goods is a product of the price of
goods multiplied by the quantity bought. Expressed in a mathematical formula this leads to
Volume needed = Price of goods produced x real GDP
When economists evaluate the shape of an economy they consider the equation:
Money circulating x Velocity of the money circulating = Price of goods produced x Real GDP
These days the problem for the developed markets is that the velocity of money circulating and the real
GDP are both low, and therefore inflation is just not starting.
From a purely practical point of view, it is clear that even when banks are flooded with liquidity and
the borrower is likely to default, the financial sector will not be ready to lend because, in theory, they
have to ultimately cover the loss. If this rule is broken then a nation can run into deep trouble and the
corresponding government must intervene under the principle of financial institutions being too big to
fail as we saw in the US and Europe. Currently companies are reducing their debts due to poor overall
economic conditions and therefore they are not willing to take additional loans. As soon as they are able
to produce and sell products they will be ready to take loans in order to increase production.
5
PEAK VALUES
Inflation in Developed Economies
The Challenges Posed by Low Velocity
Keynes’s idea to influence an economy by supplying it with liquidity is not working properly because it
does not take into consideration the effect of low velocity. During the 1950s, economists began to see the
limitations of Keynes’s theory and some improvements were made. Political and social decisions were
given higher priority. But today’s tragedy is that we have no real plan to increase velocity—that is, first
production followed by economic growth.
The looming issue is that if the unprecedented amount of money currently available in the financial
market started to enter the real economy, velocity could accelerate and set off record inflation. This is a
major concern for central bank managers. Unfortunately the financial market reacts very sensitively to
any rumour of a central bank reducing its position. Market participants really fear that liquidity could
dry up. So the question is how do we (1) maintain liquidity, (2) increase velocity, and (3) avoid future
inflation?
In the short- to medium-term, we will likely experience quite volatile equity and fixed income markets.
This will probably last as long as the real economy is not working properly and until the central bankers
manage to exit their QE strategy.
Economists often consider growth as a benchmark of how healthy an economy is. For example, the
US economy is considered to be in better shape because we can see some recovery—growth—thanks
to a reorganised financial sector. But what is this nation producing? We see more productivity in the
country’s “low skill” sector—more waiters are employed. There may be less obvious growth in the
German economy, but there the situation is actually better because the country currently needs resources
for their exports. They are producing real goods and highly-skilled jobs for workers from Spain and
other parts of Southern Europe.
Central banks can help an economy, but the economy must produce real value or it will head towards
serious trouble.
6
PEAK VALUES
Inflation in Developed Economies
How Should We Hedge Ourselves against Inflation?
Using gold as a hedge against inflation just won’t work—see the earlier article regarding the value of
gold. We need another instrument.
The next instrument could be an equity index representing the country’s economy. This is not obvious
at first sight. The correlation could be positive if the economy is producing real goods and therefore
jobs. If inflation is not extreme, the equity may be safe—but equities are by nature volatile. They are not
desirable as a hedge instrument.
Some investors are using real assets—real estate—to protect themselves. However, historical data tends
to question this hypothesis. The volatility of this asset class carries the same risks as equities.
There are fixed income instruments that are directly tied to inflation. In particular, inflation-linked bonds
are strongly correlated to a nation’s published rate of inflation. In some cases the value of the bond and
its coupons are directly linked to the country’s consumer price index (CPI). For instance, if the CPI is
5 % and the notional amount is 100, then just after the publication of the data the notional value will be
adjusted to 105. There will be a time lag, but it is more important that the way inflation is measured and
how the investor perceives or experiences it, must be congruent.
Finally we should not forget that any instrument must be bought. The market has its own view regarding
inflation. Because no inflation is in sight in developed markets at least for the medium term, for the
investor who would like to hedge against this risk, this could be an interesting alternative. On the one
hand the investor can hedge against inflation’s risk; on the other hand the index-linked bond would be
sold at a discount with respect to its expected value. In particular, for a long-term investor this kind of
instrument must be considered for his asset allocation.
7
PEAK VALUES
Inflation in Developed Economies
For any query regarding this presentation, please contact:
Peak Values AG
Loewenstrasse 62
CH-8001 Zurich
Tel: +41 44 533 41 50
Fax: +41 44 533 41 99
Email: info@peakvalues.ch
Web: www.peakvalues.ch
Disclaimer Research
The views expressed are as of October 2013 and are a general guide to the views of Peak Values AG.
This marketing publication has been prepared by Peak Values AG for informational purposes only. Any market or investment views
expressed are not intended to be investment research and do not constitute general or specific investment legal, tax or accounting
advice of any kind and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for
securities or other financial instruments. It should not be considered as substitute for individual advice and risk disclosure by a
qualified financial, legal or tax advisor. This document does not replace any product specific materials.
The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of
investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
The information and opinions contained in this document are based on publically available information and data believed to be
correct, accurate at the time and have been compiled or arrived at based upon information obtained from sources believed to be
reliable and in good faith. All such information and opinions are subject to change without notice. Care has been taken to ensure
the accuracy of its content but no responsibility is accepted for any errors or omissions herein. However Peak Values AG has
not verified and is unable to guarantee the accuracy and completeness of the information contained herein. Possible errors or
incompleteness of the information do not constitute legal grounds (contractual or tacit) for liability, either with regard to direct,
indirect or consequential damages. In particular, neither Peak Values AG nor its shareholders and employees shall be liable for
the opinions, estimations and strategies contained in this document.
Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The
value of investments and the income from them may go down as well as up and investors may not get back the original amount
invested.
A number of the comments in this document are based on current expectations and are considered “forward-looking statements”.
Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of Peak
Values AG management’s best judgment at the time this document is compiled and any obligation to update or alter forwardlooking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not
intended to predict or guarantee the future performance of any individual security, asset class, commodity, markets generally, nor
are they intended to predict the future performance of any investments.
Copying any part of this publication without the written permission of Peak Values AG is prohibited.
8