inflation, inflation, inflation graeme troy ffa april 2010
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Inflation, Inflation, InflationGraeme Troy FFA
April 2010
2
What is inflation/deflation?
Some simple mathematics
Classical Theories
– Inflation falls in a recession
– Printing money causes inflation
– Large budget deficits – Inflation is the ‘easy’ way out
– Risk assets provide good long term inflation protection
The Bank of England – what do they believe?
The General Election
Conclusion
Overview
3
What is inflation?
DefinitionThe rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.
John Maynard Keynes - EconomistBy a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
Bill Vaughan – US Industry AuthorSome idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as the culmination of your career
Source: http://dictionary.reference.com/browse/inflation, http://thinkexist.com/quotations/inflation/
4
UK Inflation Facts
If you put £1 into the Retail Prices Index in June 1947, that would be worth £29.90 today. RPI inflation has averaged 5.6%pa since 1947.
In 1906, 1 pint of beer cost two pence (old money). ‘Beer inflation’ has averaged 5.8% in the last 100 years!
In 1710, a male teacher’s annual wage was £15.78 – approximately 2.5% annualised wage inflation for the last 300 years.
In 1982, the first Sony CD player retailed for 168,000 Yen, approximately £400 then. Today, a standard CD player can be bought for £40 : ‘electronic deflation’ of 8% per annum.
Source: http://privatewww.essex.ac.uk/~alan/family/N-Money.html, http://www.igp-web.com/Carlow/wages.htm, ONS Data, http://www.sony.net/Fun/SH/1-20/h5.html
5
What is deflation?
Deflation is a decrease in the general price level of goods and services. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money
JapanThe only real modern-day example where deflation has had periods of persistency
Source: Wikipedia, Bloomberg.
6
UK Inflation Measures
RPI – The Retail Price Index- 24% of the index comprises housing: much more volatile than CPI - More common in pension fund liabilities- UK government bonds track this index- Index data back to June 1947
CPI – The Consumer Price Index- Probably the most important in terms of economic policy- BoE charged with targeting 2.0% CPI at a two year time horizon- If current CPI prints below 1.0% or above 3.0%, the Governor must explain this in writing to the Chancellor- Relatively new index (1989)
Other indices- Average Earnings Indices- Big Mac index (Currency/Inflation trade-off, Economist magazine)
7
Simple Mathematics – Beware ‘Base Effects’!
CPI & VAT: In Dec-08 VAT was cut from 17.5% to 15%, and reversed in Jan-10
Feb-08 Feb-09 Feb-10CPI Index 106.3 109.6 112.9Inflation rate 3.1% 3.0%
So despite negative base effects due to VAT, inflation remained above target in the UK in 2009
0Index
IndexInflationIndex tt
Now suppose a tax change reduces the index by 2% T1 but is reversed T3, with all else unchanged
T0 T1 T2 T3Index 100 100 104.9 108Inflation rate 0.0% 4.9% 3.0%
Inflation over the entire period is unchanged, but T1 and T3 rates have been impacted by ‘base effects’
T0 T1 T2 T3Index 100 102 107 108Inflation rate 2.0% 4.9% 0.9%
8
Theory 1: Inflation falls in a recession?
9
UK CPI during the recession
The Theory
Companies reduce prices to survive
Unemployment – lower demand
People save more, spend less
What has happened
CPI currently > 1% above target
CPI averaged 2.2% in 2009
Petrol prices at all time highs
16 of last 23 prints upward surprise0
1
2
3
4
5
6
Sep-07 Sep-08 Sep-09
CPI Y
oY In
flatio
n
Source: CPI data, Bloomberg
10
Why has UK Inflation Been So ‘Sticky’?
[1] The CurrencyThe UK is a net importer of manufactured goodsSince 2008, Sterling is down approximately 25% against most of its trading partnersLagged effects from the currency estimated to be roughly 30 months
Source: Currency lagged effects: Michael Saunders, Citigroup economist.
[2] Pricing Power / OligopoliesDuring a deep recession, smaller companies tend to go bustLarger companies enter ‘survival mode’Oligopolies are formed – only a few dominating companies exist (eg UK banking)Companies then can and will push prices higher
[3] Redistribution of WealthThe Base Rate fell from 5.5% to 0.5%Most consumers in the UK have large debts – particularly their mortgagesThe costs of servicing existing debt has generally fallen for most peopleThe majority of people have much more disposable incomeThis is at the expense of the extra 2.5% of people made unemployed
[4] OilGlobally, demand for oil has remained resilient – UK is insignificant on a global scale for oil demandOil is priced in $Oil impacts many areas – petrol, public transport, transportation of food, plastics
11
Can these pressures fade?
The CurrencyLagged effects from the currency likely to tail off in the next twelve monthsMore confidence after the General Election?
Source: Currency lagged effects: Michael Saunders, Citigroup economist.
Pricing PowerAs the economy starts to recover, new entrants may join the marketIncreased competition should squeeze margins and feed into lower prices
OilOver the (very) long term, slow move toward alternative energies
12
Theory 2: Printing Money leads to inflation?
Images past and present
13
Germany 1923Germany 1923 Zimbabwe 2008Zimbabwe 2008
Source: http://www.marketoracle.co.uk/Article5713.html, wikipedia
July-08 inflation rate estimated at 231,150,888.87%July-08 inflation rate estimated at 231,150,888.87%1923 inflation – prices double every two days1923 inflation – prices double every two days
14
The quantity theory of money
M x V = P x QM = Quantity of money in circulation V = Velocity of circulation
P = Price Level associated with transactionsQ = Real Growth expenditures (eg GDP)
V , Q assumed stable. So Increasing M => increasing P?
In the UK the BoE printed £200bn – 15% of GDP, between Mar-09 and Jan-10
The assumption that V is stable is critical
Currently V is broken – banks aren’t lending, consumers are saving more, spending less
If V begins to pick up, it is vital M is reduced or V is kept in check
M can be reduced by selling back the gilts it currently owns, issuing new debt
V can be kept lower via fiscal measures / public spending cuts / higher interest rates
15
Theory 3: Large Budget Deficits => High Inflation?
16
Early 1970s
Annual budget deficit ran between 5-10% of GDP
RPI was as high as 27%, consistently above 10%
Mid 1990s
Deficit requirement blew out to 6% of GDP
Economic growth reduced deficit, inflation stable
BoE independence 1997 – inflation targeting
Now
£1.3 TRILLION outstanding debt by 2015 (2010 Budget)
Political Uncertainty
Source: Datastream.
Large Budget Deficit => High inflation?
17
Theory 4: ‘Risk’ assets provide inflation protection
18
Asset Classes – Inflation Protection?
Gold
– Historically countries used to link their currency to the Gold Standard
– Central banks can print money, they cannot print gold
– Limited supply
Property
– Rents typically reviewed every five years
– Capital values move with affordability – if profits / incomes move in line with inflation, capital values and rents will
move in similarly
The Classical Interpretation
Equities
– Revenues and Expenses generally rise in line with inflation
– As a result so do profits
19
Starting Points Are Critical
Since 1986
0
2
4
6
8
10
Dec-86 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06
Valu
e of
£1
RPI GOLD (GBP) FTSE A/S Property
2001 to 2009
Source: Bloomberg, Gold spot Oz / GBPUSD, Property = IPD Index
0
0.5
1
1.5
2
2.5
3
3.5
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
Valu
e of £
1
RPI GOLD (GBP) FTSE A/S Property
20
The Bank of England
21
The BoE
Target 2% CPI two years ahead
Fan Chart shows potential outcomes
Believe key risk is still low inflation
Suggest Base Rates on hold for long time
The BoE Quarterly Inflation Report
CPI projection - constant Base Rate 0.5% and £200bn QE
Source: Bank of England February-10 Inflation Report, SWIP assumption CPI = RPI -0.8%
The Market
Little chance of rate hikes this year
Medium term CPI at 3% - well above BoE
Election uncertainty
22
Election : Inflation Inflation Inflation?
23
Spending Cuts / Taxes / Growth
Higher taxes on incomes serve to dampen inflation expectations in general
The economy is a key focal point – in particular how to deal with the deficit. The major parties agree more needs to be done to reduce the deficit, but disagree on the method
Current polls suggest the election outcome is highly uncertain – and so is the economic outlook
Public spending cuts can increase unemployment and reduce inflation expectations
Higher taxes on goods and services (VAT) will increase very short-term inflation, but erode consumer spending power in the medium-term
All these measures are unpopular – the economic environment will depend on the extent of any working majority or levels of co-operation in a hung parliament
Economic recovery plays a key role in reducing the deficit - ideally fiscal and spending measures wouldn’t harm recovery too much
24
CONCLUSION
25
Asset classes can offer inflation protection over the long term but starting points are crucial
Printing money doesn’t necessarily lead to inflation (though it does devalue your currency)
Inflation doesn’t necessarily fall in a recession
‘Politics’ and ‘Tax’ – may only be worth half a mark in an actuarial exam but their macroeconomic implications can be critical
The link between budget deficits and inflation is not clearcut
26
A Final Thought
Ronald Reagan – President
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”
Source: http://thinkexist.com/quotations/inflation/
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