More Inflation Please, the Ogre is Coming

It can’t get much clearer. Prices aren’t going up quickly enough for the head of the IMF, Christine Lagarde. Falling prices (AKA deflation) threaten to derail the economy, she reckons.

The Financial Times reports:

“With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery,” said Ms Lagarde, in a speech at the National Press Club in Washington. “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

Our Family Wealth expert Vern Gowdie agrees that deflation is on the horizon.  Though he’s no fan of Lagarde’s, having previously labelled her ‘a socialist politician with zero experience in banking’, he thinks deflation will wipe out huge amounts of wealth in the years to come. Click here to find out why.

But it won’t happen if our heroic central bankers can help it. Here’s more from Lagarde:

Central banks should return to more conventional monetary policies only when robust growth is firmly rooted.

Your editor would suggest that robust growth is already firmly rooted. But that might get lost in the translation. In the meantime, Lagarde has sent a clear message to the world’s central banks not to tighten policy until inflation is firmly entrenched. Not that they need any encouragement.

But what type of inflation? This is a crucial question. The lack of any type of nuanced answer shows just why the global economy remains in a precarious state five years after Lehman blew up.

We’ll get into the nuances of inflation in a moment, but first a quick word on China’s latest credit data. Aggregate financing (a broad measure of credit growth) for the month of December fell more than expected. Still, monthly growth of US$204 billion means the credit system is still pretty robust.

M2 money supply rose 13.6%, again slower than expected but well ahead of China’s economic growth rate so nothing too disturbing in the numbers.

The thing to keep in mind here is that the slowdown remains subdued and planned. The People’s Bank of China (PBoC) tightened liquidity in December, which is why the ASX200 took a dive in the first half of the month.

Managing a credit slowdown from crazy to less crazy is relatively easy. The real danger will surface in 3–6 months time as the credit slowdown takes its natural course…just as much from exhaustion as from the desire of the PBoC to tame it.

That’s the point where the malinvestments from the boom will surface. That’s when it will become apparent that the cash flows supporting interest repayments on debt (or the cash flows delivering income on people’s ‘investments’) are actually sourced from taking on new debt…that they are not coming from the underlying asset itself.

We think this is such a blatant risk because new research showed that in 2013, new yuan loans by the traditional banking sector accounted for 51.4% of total loans, a record low. But it was only slightly lower than the 2012 figure of 52%. That means for the past two years, while credit growth ran wild, the ‘shadow banking’ sector, which is basically unregulated lending, accounted for nearly half of all new credit growth.

And much of that was the state owned banks channelling funds through high interest, high risk ‘wealth management’ products to get around state directed loan quotas.

Anyway, let’s see how China goes trying to control the credit slowdown. Call us a sceptical free market capitalist, but we reckon it’s a task that will overwhelm today’s pin-up socialists.

Getting back to Largarde’s, and central bankers’, fear of deflation. Does it seem a little obsessive to you, dear reader? After all, where is the deflation? It’s certainly not in asset prices. Over the past few years, the good old boys in the central banking club have pulled off the most successful reflation in history.

It’s been so successful, in fact, that if it falters now, we’re apparently going to be in a world of ogre-filled pain.

So no deflation in asset markets. Just rampant inflation. But the world’s financial overlords don’t even consider asset price inflation to be inflation at all. According to them, it’s ‘wealth’.

Their one-dimensional approach to the inflation/deflation theme is goods and services inflation. But even according to the highly cooked official measures of goods and services inflation, you’re not seeing outright deflation in any major economy.

We say highly cooked because there are all sorts of strategies to hide inflation these days. There’s the official ones like ‘hedonic adjustments’ and market based ones like shrinking packaging and lower quality ingredients…even restaurants re-jigging their menus with lower quality meat cuts and cheaper ingredients to keep prices low.

That wouldn’t be a necessary strategy if wages were keeping pace with ‘real’ inflation.

But you can’t really hide inflation when it comes to beer. They tried it in Sydney years ago with the emergence of the shameful ‘schmiddy’, a cross between a schooner and a middy, with a schooner price tag. And while everyone grumbled about it, it was apparently worth the price to drink at an ‘upmarket’ pub.

Now you can’t get away with buying a pint in Melbourne for much under $10. It’s a national tragedy.

But we digress…

So where exactly is this obsession with deflation coming from?
It serves two purposes. One is to provide cover for central banks to stimulate for as long as they can. The whole purpose of easy money is to raise the price level and ‘inflate’ away the debts of the irresponsible.

This avoids the need to write down and restructure bad debts. To do so would hit banks’ profitability. And we all know banks are off limits when it comes to taking responsibility for previously poor lending decisions. So the little man pays through the subtle inflation tax.

The irony of the whole thing though is that current central bank policies merely create vast amounts of speculation and asset price inflation. This raises the risk of a destabilising asset price bust that will REALLY bring about the risk of a deflationary depression.

Only this time people will finally see that the central bankers were the primary cause of it. When this happens, confidence evaporates and the game is up. To avert a meltdown of historic proportions, markets will probably close for a few days while the rules of the game change. But that possibility is over the horizon at this point.

Still, when it arrives much wealth will be lost. Inflation and deflation are two sides of the same coin. One leads to another. And the more inflation you have, the greater the deflation that will come after.

With people like Lagarde calling the shots, it’s no wonder the world has problems. And sorry to say, these problems aren’t going away. They’ll fester under the surface and then one day will explode, revealing these people as the frauds that they are.

Greg Canavan+
for Markets and Money


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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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