How Much Inflation Is Too Much to Ignore?

How Much Inflation Is Too Much to Ignore?

All around the world, inflation is surging, even by governments’ own measures. And central bankers are in a state of panic, even by the media’s own commentary.

The world is terrified by the prospect of tighter monetary policy — less QE and higher interest rates.

What would that mean for the investment assets we all hold to fund our retirements?

Back to that question in a moment. First, the data that has everyone in a panic…

The United States Personal Consumption Expenditure (PCE) Index, which is viewed as a more reliable indicator of inflation than the Consumer Price Index (CPI) we usually hear about, recently rose to its highest level since 1982.

The 6.5% inflation rate falls to 6.1% when you strip out volatile parts like food and energy…which is still the highest since 1983.

In Germany, inflation is now well above target and accelerating — 3.4% for August year-over-year is the highest level since 2008. The highest selling tabloid in Germany is all over this news, on its front page, no less. The Bundesbank predicts 5% inflation in Germany by Christmas. Frohe Weihnachten from the European Central Bank…

Germans have responded by increasing their gold purchases. In the first half of the year, German bar and coin purchases rose 35% compared to the previous six months, and the rest of the world saw a 20% increase. That’s not supposed to happen in a civilised Western culture, which has nothing to fear from its monetary system…but Germans know better.

For the Euro area as a whole, inflation is also well above target at 3% — the highest level since 2011. The UK’s Telegraph reckons this ‘Eurozone inflation shock piles pressure on [ECB president] Lagarde’ and ‘Prices rise at fastest pace for almost a decade this month, causing “sweaty palms” for the European Central Bank, warn economists’.

In the UK, the Bank of England has finally caught up with its recently retired chief economist and announced that it now expects inflation to rise to 4%. That’d be a 10-year high. And double the 2% target.

Australia…well, we’re still stuck in COVID lockdowns, and yet inflation is already running hot at just under 4%.

Despite all this inflation…

Monetary policy remains extraordinarily loose

So far, central bankers have stuck to their line that inflation is transitory, for a long list of reasons. And so, they’ve kept their extraordinary monetary policy in place. This amounts to a whopping level of QE and record negative interest rates in bond markets as a result.

The Federal Reserve is still purchasing a minimum of $120 billion of bonds a month, which has consisted of $80 billion of Treasury notes (short-term government bonds) and $40 billion of agency mortgage-backed securities (MBS) recently. Interest rates remain at 0%.

At the European Central Bank, interest rates remain at zero and QE at a rate of €100 billion a month.

The Bank of England is expected to complete its current round of QE by injecting the remaining £50 billion by the end of this year.

The Reserve Bank of Australia’s AU$4 billion a week QE will continue, and rate hikes aren’t expected until 2023. RBA Governor Philip ‘the low rate’ Lowe explained he ‘will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range.’

Erm, Phil, it’s well above 3%…

And how long is this ‘sustainable’? And isn’t it your job to make sure inflation is not above 3%? And doesn’t it have to be below 3% to be sustainably between 2% and 3%?

But the RBA is far from alone, remember. So far, very few central banks have had the guts to do what they’re supposed to and raise rates.

For the rest, this combination of inflation and QE would likely give their central bankers of the past a heart attack, let alone sweaty palms.

The question is, what will the modern lot do?

Which is more important? Inflation or wealth?

Central bankers now face a choice. And it’s a dreadful one.

On the one hand, they are legally bound to reign in inflation with tighter monetary policy.

On the other hand, hiking rates or cutting QE would likely cause the asset bubble they have inflated to pop. In my opinion, governments would go bust, but that’s another story.

You see, all asset classes benefit from monetary stimulus. Stock valuations rise for a long list of reasons, including discount rates, the hunt for yield and stocks’ ability to rise with inflation.

Bonds are bid up in price to reflect the lower yields.

Property soars as borrowers can afford to borrow more debt.

And real assets that keep pace with inflation become more popular in the attempt to escape the burning theatre of cash.

So, what happens when stimulus is withdrawn as inflation rises too far?

Stocks fall as corporate debt becomes more expensive, which reduces profits, and bonds become relatively more attractive to invest in. The bid drops out of the property market, and mortgage defaults begin. Bonds crash as yields rise.

Just as central bankers have inflated the everything bubble, and all bubbles in the past, they also pop them with tighter monetary policy…eventually.

This is what the market fears a repeat of in coming months.

Isn’t inflation just transitory?

The line that inflation is transitory is wearing thin on consumers and voters. Especially in Germany, where fear of inflation is engrained in children in primary school with rhymes about ‘money creation is money devaluation’.

The big question now is, how much inflation is too much to ignore?

And which way will central bankers choose? Will they keep asset bubbles bubbling or try to bring down inflation?

History doesn’t give a very clear one-sided answer. For every tight central banker, there has been a loose goose. For every Paul Volker a Rudy von Havenstein, who blew up the German currency during the Weimar hyperinflation. For every post-Weimar Germany, there is an Argentina.

If you take a look at the current crop of central bankers, inflation definitely seems more likely. In the US, you have an investment banking insider at the helm and at the European Central Bank a lawyer like von Havenstein was. This is a dangerous combination.

Whatever does happen, it’s time for me to sign off. Six Japanese fighter jets just took off over my head in unusually fast succession and an alarm sounded in the distance…

No doubt Bank of Japan Governor Haruhiko Kuroda will be on shortly to assure us that all is well, and he’ll add a trillion to the monthly purchases just to make sure.

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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