On to Wikipedia's take...
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The term "inflation" once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of money-a loss of purchasing power. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.
Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. Inflation may widen an income gap between those with fixed incomes and those with variable incomes. High inflation may lead to shortages of goods as consumers begin hoarding them out of concern their prices will increase in the future.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. The consensus view is a sustained period of inflation is caused when money supply increases faster than the growth in productivity in the economy.
The task of keeping the rate of inflation low is usually given to monetary authorities who establish monetary policy. Generally today these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
And the flipside of the argument:
Monetary inflation is the term used by some economists to differentiate direct inflation in the money supply (or debasement of the means of exchange) from price inflation which they view as a result or necessary outcome of the former. Originally "inflation" was used to refer simply to monetary inflation, whereas in present usage it often refers to price inflation. The Austrian School of economics makes no such distinction, maintaining that monetary inflation is inflation, there being no difference between the two.
The description of the actual mechanism and relationship between price inflation and monetary inflation varies according to each school, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms. Although the system is complex and there is a great deal of argument on how to measure the monetary base or how much factors like the velocity of money affect the relationship, and even more disagreement on what is the best monetary policy, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation. Inflation targeting is advised by followers of the monetarist school, while Austrian economists advocate the return to genuine free markets, which would entail the abolition of the state-sponsored and protected central bank, which protects and supports and controls modern fractional reserve banking and advocate instead free banking or (more often) a return to a 100 percent gold standard.
And putting it all together...
Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. The portmanteau "stagflation" is generally attributed to British politician Iain Macleod, who coined the term in a speech to Parliament in 1965. The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as mutually exclusive, and also because stagflation has generally proven to be difficult and costly to eradicate once it gets started.
Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable. This type of stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets; together, these factors can cause stagflation. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.
John Maynard Keynes wrote in The Economic Consequences of the Peace that governments printing money and using price controls were causing a combination of inflation and economic stagnation in Europe after World War I. Stagflation was also a very serious macroeconomic problem in the 1970s. In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st century began with America going one way to fight recession and Europe going the other way to fight inflation.
If necessary, reread the section above and think of:
- OPEC's curtailing of oil production to raise prices;
- the meteoric drop and potential retracement of oil prices;
- the concerted global helicopter ride used to shower money all over the place;
- the amount of regulation about to come down the pike as a result of banks and insurers accepting public bailout monies;
- the amount of regulation coming down the pike as a result of nationalism and isolationist policies re-emerging;
- the amount of regulation coming down the pike with an all democratic government elected at the nadir of the worst financial crisis caused be lax regulation known to this country. I love Obama, and this country - and world - needs him, but without a balance of power (ex. repubs and dems) things may not go the way they should. Just imaginge a filibuster proof legislature leaning to just one side, with a matching president. I hope our President Elect has the fortitude and courage to do the right thing. Thus far, he has executed near flawlessly. though;
- the effective price controls the EU, UK and US are using by watering down the mark to market rules for financial institutions, the ban on short selling, and the attempts at the government buying private securities in an attempt to affect private, free market prices. This, my friends, is price controls at a new level.
Food and fuel prices, the main triggers (Note: Reggie Middleton content from here on)
Commodity and fuel price-spurred inflation has put economies across the globe on the ropes. The price of crude doubled from US$73.39 per barrel on July 2, 2007, to US$147.47 in July 2008. The consequent increase in cost of production pushed up prices of other commodities keeping inflation high. The credit crisis has also had a bearing on inflation since September 2008. While lower demand due to the financial crisis pushed crude oil prices down to US$71.7 per barrel on October 17, 2008 (and currently in the mid-sixties), inflation has not returned to July 2007 levels yet, despite a drastic slowdown in nearly all of the world's major economies and emergining markets. This may be exacerbated by the largest concerted, global fiscal and monetary stimulus the world has ever known. This is how I make my money. See The Great Global Macro Experiment, Revisited.
Food prices rose more than 60% between December 2006 and July 2008, adding to inflation. Food prices increased largely due to increased demand for biofuel and inadequate rainfall in food grain producing countries. Virtually all commodities surged due to strong global growth during 2005-2007. Booming economies increased industrial activity and (consequently) demand of intermediate inputs such as metals and agricultural raw materials. This coupled with low inventories increased prices. However, the slowdown in global growth and the anticipated decline in demand for commodities are expected to dent prices. Commodity and fuel prices have already come off recent highs due to the financial turmoil and recessionary fears. However, inflation has not declined significantly due to second-round effects of underlying inflation.
Food prices stopped rising as the financial crisis widened. The UN Food & Agriculture World Index, which had risen over 80% between December 2005 and June 2008, has started falling. The index shed 14% to 188 in the three months ended September 30, 2008, due to the sharp fall in energy and biofuel prices.
Most Central Banks increased key interest rates and reserve requirements prior to September 2008 to squeeze liquidity from the financial system and restrict inflation. Governments across the globe took both fiscal and monetary measures to tame the inflation dragon and keep prices under control. By squeezing liquidity governments hoped to restrict demand and sustain prices of essential goods at low levels. These measures were not completely successful as emerging nations provide subsidized fuel and food to end users. The inflation was mostly "imported" (food items grew scarce and the government had little control over rising energy prices).
September 2008 brought its own set of problems. The global financial turmoil gripped Wall Street. Several financial institutions and banks went under as liquidity in the banking system dried up in reaction to the increase in reserve requirements and key lending rates prior to September 2008. Higher interest rates hurt credit growth and (consequently) demand. Misgivings about the financial system also led to a freeze on credit, which dented commodity and fuel prices.
The ongoing credit and liquidity crunch is forcing major economies to decrease key interest rates at a rapid, and potentially perilous rate. This could easily set the framework for explosive inflation in the future. The central banks of several countries have pumped in huge amounts of money into the financial system to improve investor confidence. The Federal Reserve, the European Central Bank (ECB) and the Bank of England (BOE) also reduced key lending rates by 50 basis points each to 1.5%, 3.75% and 4.5%, respectively. These efforts are expected to increase liquidity and drive inflation higher. Though key lending rates have come down, lack of confidence has hindered lending between banks. Banks have also reduced lending to companies and individuals. As a result, the expansion plans of many companies have been put on hold. Governments across the globe are now working to instill confidence in the banking community and encourage lending.
The United States
US economic growth averaged over 3.0% during 2004-2007. A reduction in the US Federal Reserve Rate from 5.25% in June 2006 to 2.25% in March 2008 also increased liquidity. The consequent increase in demand for commodities and fuel pushed inflation to a high of 5.60% in July 2008. However, as the credit crisis widened, demand for commodities waned. Inflation declined marginally to 5.37% in August 2008.
Inflation increased mainly due to the sharp rise in commodity and energy prices. Commodity prices increased 46.9% y-o-y in August 2008. The Energy Index gained 66.9% y-o-y in August 2008. There has been some moderation in global inflation since July 2008 due to the decline in commodity and energy prices. The Commodity Price Index declined 10.7% m-o-m in August 2008, while the Energy Index declined 12.6% m-o-m. Commodity prices are likely to decline further due to economic slowdown. The IMF expects US GDP growth to decline to 1.3% in 2008 from 2.0% in 2007. High relative inflation and the credit turmoil are expected to continue inhibiting economic growth.
The Euro area has witnessed an unprecedented increase in inflation since August 2007. After reaching a high of 4.0% in July 2008, inflation declined marginally to 3.6% in September (higher than the European Council limit of 2.0%) compared to 1.9% in 2Q 07. Though inflation has come down slightly, it still poses threat to economic growth. If we exclude food and energy, inflation grew 2.6% in August 2008 (the highest growth since September 2007). High inflation and the current credit crisis are the greatest threat to economic growth in the Euro area.
Food inflation increased 7.2% in July 2008, the fastest growth since 2000. Though food inflation decreased to 6.8% in August 2008, its contribution to overall inflation was high. Greater economic activity increased demand for commodities and (consequently) prices. Energy inflation averaged 3.1% in 2003, 7.9% in 2006 and 13.1% in 2008 (until August). These factors are keeping inflation at record highs. According to the Organization of the Petroleum Exporting Countries (OPEC), the global economic slowdown would reduce demand for crude oil by 2.7% in 2009. This could dent crude oil prices, which tumbled to US$71 per barrel on October 17, 2008, from US$147.47 in July. As of today, oil is $63.90. While a reduction in crude oil prices would reduce inflation slightly, the challenges to economic growth are likely to remain.
In India, inflation hovered significantly above 5.0%, the level the Reserve Bank of India (RBI) termed "acceptable." Inflation grew above 10.0% during the last four months due to soaring commodity and fuel prices, peaking at 12.63% on August 9, 2008. Inflation declined to 11.44% on October 3, 2008; however, there appears to be no further reprieve of extreme significance and economic growth is likely to decelerate considerably. Rising inflation forced RBI to tighten the monetary policy-the central bank raised reserve requirements and lending rates to commercial banks, squeezing liquidity out of the banking system at a time when I believe it is in dire need. These measures restricted inflation; nevertheless, Asian Development Bank expects India's economic growth to decrease to 7.4% y-o-y in 2008 from 9.1% in 2007. The spread of the credit crunch from US to India forced the Reserve Bank of India (RBI) to take stern measures to improve liquidity in the banking system. RBI reduced the cash reserve requirement by 250 basis points to 6.5%, for the first time since 2004, on October 15, 2008. It also cut the repo rate by 100 basis points to 8.0%. As liquidity improves, inflation is likely to increase. These measures will end up further restricting growth.
In China, inflation declined from a 12-year high of 8.7% in February 2008 to 4.9% in August. Though inflation has come off highs, it is mainly driven by food prices. The growth in food prices declined to 10.3% y-o-y in August 2008 from 14.4% in July, keeping inflation high. Inflation is likely to decline further as commodity and fuel prices across the globe regress. The caveat is that we see China's growth slowing much faster than the reprieve in inflation. See the Chine-specific sections of The Butterfly is released!, Global Recession - an economic reality, and my China Macro update accented by media accounts.
Inflation in the Gulf Cooperative Council (GCC) region has been increasing at a rapid pace. GDP growth averaged 7.3% during 2002-2007 sustaining demand. Consequently, inflation increased from 0.3% in 2001 to 6.3% in 2007. Inflation in Kuwait more than doubled to 11.4% in April 2008 from 5.4% in April 2007. Inflation in Saudi Arabia and Oman rose to 10.4% and 13.2%, respectively, in May 2008 from 3.0% and 4.3% the previous year. The exchange rate regimes followed by GCC nations is one of the main reasons for high inflation-all GCC nations, except Kuwait, have pegged their currencies to the US dollar. When the US Federal Reserve reduced the interest rates during 2006-2008 to boost the US economy and avoid recession, inflation in the GCC region increased due to the currency peg. Rising commodity and energy prices compounded this problem.
Economic growth across developed, emerging markets decelerates
The afore-referenced financial fiasco forced major central governments to take major, mostly reactionary steps to revive economic activity. The Federal Reserve expects its US$700 billion bailout plan, which was signed on October 3, 2008, after much debate, to revitalize the US economy. I expect it to fail, utterly. The first tranche, an investment of US$125 billion in the equities of nine major financial institutions, was implemented on October 14. This was supposed to spur lending by the recipients as authorities hoped it would thaw the frozen banking sector through added liquidity and increased confidence. See Corporate welfare for a quick recap of the results. The Federal Reserve also cut the key federal funds lending rate by 50 basis points to 1.5% on October 8 to facilitate free flow of credit. Fear of recession may force the Federal Reserve to consider another lending rate cut on October 28-29. To propel short term lending, the Federal Reserve increased the Term Auction Facility (TAF) for both 28-day and 84-day auctions by US$150 billion each. This implies that by December 2008 the Federal Reserve would have TAF credit outstanding of US$900 billion. Despite these measures to encourage lending, financial institutions are nervous. The Fed created a Commercial Paper Funding Facility, which will purchase unsecured and asset-backed commercial paper and provide short term financing to corporate entities. These measures by the US government and the Federal Reserve have calmed those who feared an immediate collapse of the banking system. Unfortunately, for those who weren't paying attention, the shadow banking system - that network fo unregulated and quasi-regulated bank equivalents, utterly and totally collapsed in period mere months. The economic, financial and logistical aftermath of which we are just now starting to realize.
Emerging nations are also experiencing economic slowdown due to globalization. High commodity and fuel prices were the main triggers. Inflation in China surged above 8% in February 2008; in India, it hovered above 11% for 18 weeks ended October 3, 2008. The consequent increase in lending rates hurt credit growth. The collapse of Lehman Brothers and the nationalization of leading US banks and insurance companies sparked fear and panic among investors. Many withdrew money from equity markets. The sharp fall in the US equity market forced global investors to withdraw money from emerging markets. Skepticism about the exposure of emerging nations' financial institutions to the US economy triggered a meltdown in equity markets. The huge outflow of FII money and declining confidence also sapped liquidity out of emerging economies. Central banks in many emerging countries intervened by reducing key lending rates and reserve requirements. While short term credit increased as a consequence, the real effect of the reduction in reserve requirements will manifest itself once credit begins to flow, in the form of _____________ (I'll let you foll in the blanks)... High inflation and the credit crunch has dwindled economic growth and it may be quite a while before confidence in financial institutions is completely restored.
Slowdown in Eurozone; UK, Germany, France, Spain and Italy following the US
The Eurozone has been highly impacted by rising inflation (due to high fuel and commodity prices) and the financial crisis. Inflation increased from 1.7% in August 2007 to 4.0% in July 2008 before sliding to 3.6% in September 2008. The credit crisis has translated to a slowdown in economic activity, as reflected in the 0.2% y-o-y contraction in GDP growth in 2Q 08. The fallout of the credit crisis forced policymakers to bailout several banks. Many European nations also formulated huge bailout plans. Collectively, the Eurozone bailout plan is estimated at €1.7 trillion. This amount would be used to purchase faltering banks, guarantee loans and increase liquidity. Germany drafted a €500 billion bailout plan to infuse liquidity and prevent bankruptcies. The UK infused £20 billion into the Royal Bank of Scotland and £17 billion into HBOS-Lloyds TSB to improve liquidity and resuscitate the banking sector. The injection of liquidity was designed to not only end the Domino Effect but also encourage banks to start lending to each other. (again, I reference Corporate welfare in order to guage its effectiveness). France is infusing €360 billion to help banks overcome the current financial crisis. However, despite these initiatives, investors remain wary and equity markets continue to freefall.
The slowdown in the Euro services sector is reflected in the Services Purchasing Managers Index, which declined to 48.4 in September 2008 from 48.5 in August. To trigger economic growth, ECB reduced the key lending rate by 50 basis points to 3.75%. However, its efforts to increase liquidity and restore confidence have been in vain. The Euro area, which contracted 0.2% y-o-y in 2Q 08, is likely to experience technical recession (i.e., contraction for two consecutive quarters) in 3Q 08.
Japan - Lower export earnings indicate tough times ahead
Japan's dependence on exports has increased its vulnerability to the global financial turmoil. Japanese equity markets were trading at three-year lows. The benchmark Nikkei 225 Index declined 24.3% during the week ended October 10, 2008. The share of exports in GDP growth increased from 9.8% in 2001 to 16.5% in 2007. Japan's GDP grew 1.3% in 2001 and 2.2% in 2007. Economic deterioration in the US and Europe, the main markets for Japanese exports, is decelerating the pace of growth in Japan. Lower demand for goods and services from the US and Europe, constituting 34.4% of total exports in 2007, dented the Japanese economy. Factors such as negative GDP growth in 2Q 08 (3% annualized) and lower export earnings in August 2008 are pushing the economy to the brink of recession. It is worth noting that the US accounted for 21.9% of total Japanese exports during 2003-07. As US growth subsides, demand from the US is likely to decline further. The monthly exports growth to the US declined 21.8% y-o-y in August 2008 from a high of 20.3% y-o-y in September 2006. The sharp decline in export earnings from the US is hurting the Japanese economy severely. Exports to the Euro area (14.6% of total exports in 2007) contracted by 3.5% y-o-y in August 2008 compared to 24.0% in September 2007. As the financial crisis spreads and demand from the US and Europe declines, the Japanese economy would contract even further.
Source: Ministry of Finance
The high dependency on exports has sensitized the Japanese economy to global economic growth. The anticipated decline in the global GDP from 5.0% in 2007 to 3.9% in 2008 is expected to impact Japanese exports. The IMF has estimated global GDP growth at around 3% in 2009. The credit crisis compounded the problems of Japanese companies. To alleviate woes, Bank of Japan signed Dollar-Yen swap agreements worth US$60 billion each with the Federal Reserve Bank of New York on September 18 and 29. The agreements injected fresh capital into the financial system, increasing liquidity.
A stable Japanese Yen is very important for international trade. The recent appreciation of the Yen in relation to the US dollar made exports unfavorable. The Yen had appreciated 9.2% over the average for 2007 until October 19, 2008, and 17.2% from its high on June 22, 2007. It did not appreciate in relation to the Euro, based on the average for 2007 and 2008. However, the Yen appreciated 16.9% from its high on July 18, 2008. The Yen increased sharply due to ongoing turmoil in countries with strong currencies. This translated to huge buying of Yen. The rapid appreciation of the Yen is likely to negatively impact exports and dampen economic growth. An unstable Yen could also hurt global forecasts and hinder Japan's growth.
China and India - The Decoupling theory made for flowerful prose, but the reality is passé
The GDPs of China and India, the leading economies in Asia, grew over 9.0% in 2007. China is an export-driven economy and demand from the US and Europe influences its growth. Exports to the US and the Euro area account for 38% of total Chinese exports-the US alone accounts for 22%. Consequently, any slowdown in demand from these regions would negatively impact growth in China. Though India is largely a domestic demand-driven economy, the global economic recession could severely dent its growth prospects too, either directly or indirectly.
Besides their reliance on the US and Europe, China and India also depend on each other. Chinese and Indian equity markets have been in freefall ever since the global financial crisis intensified. The Dow Jones Industrial Average had declined 32% YTD as of October 16, 2008. In comparison, China's benchmark Shanghai Composite SE index is down 64% YTD, while India's benchmark index, the Sensex, is down 48% YTD. The S&P 500 index is down 31% YTD. Though concurrent, the fall in Chinese and Indian equity markets has been more severe relative to the Dow Jones.
Will bankruptcies increase? First, read "The Butterfly is released!"
Number of banking institutions in distress rising
The global financial crisis has pushed many banks to the brink of bankruptcy; in fact, some are already filing for bankruptcy. The risk of systemic collapse forced governments to nationalize several banks - the US, UK and EU governments picked up stakes in banks to prevent bankruptcies. Nevertheless, the loss of confidence in the banking sector has restricted credit. To boost the economy, the Federal Reserve injected US$250 billion in the equities of the large banking firms. On October 17, 2008, the US Federal Reserve injected US$125 billion in nine banks - Citigroup, JP Morgan Chase, Morgan Stanley, Goldman Sachs, Bank of America Corp, Merrill Lynch & Co, Wells Fargo & Co, State Street Corp, and Bank of New York Mellon - with high exposure to the subprime mortgage crisis. As of October 1, 2008, the US banks had loans and advances worth US$7.25 trillion-real estate loans constituted US$3,780 trllion, or 52% of this. With the risk of defaults increasing, these banks would be most prone to working capital inadequacy in the short to medium term, despite the huge capital infusion.
To strengthen the financial system, the FDIC temporarily increased the insurance cover on banks deposits and non interest bearing deposit accounts to US$250,000 per depositor from US$100,000. This higher insurance cover would be applicable up to December 31, 2009. FDIC increased the cover to restore confidence among depositors who withdrew money in panic. This is, from a practical perspective, a non-issue though. Those who will do the most damage to the vulnerable banks are high net worth investors, small and medium sized business, and simiarl institution. These entities average much higher balances than $250,000, while the average consumer has a balance considerably below $250,000. So, while it may sound good to the layperson, the experience practitioner should know better, and so should the government. Consequently, skepticism about the FDIC's ability to bailout institutions with very toxic assets increases the likelihood of additional bankruptcies. The FDIC has hinted at a requirement of US$150 billion by 2009 as the number of bankruptcies increases. FDIC's list of troubled banks increased from 90 to 117. The FDIC has also shortlisted 1,479 institutions (with assets jointly worth US$3.2 trillion) that have a high risk of failure. This is an alarming number.
The worst financial crisis since the Great Depression of 1929 is far from over and there is no certainty about how much more pain it will inflict. Losses by leading financial institutions have increased the risk of bankruptcies. Total writedowns increased to US$662.7 billion (US$407.7 billion in the US alone) on October 20, 2008. The credit crisis has also increased the risk of bank failure. The impact of the US$700 billion bailout package will not be immediate as investors are nervous and have serious misgivings - and rightfully so. In retrospect, the US, Euro area and Japan are in for a prolonged U-shaped recession.