The Battle of Inflation rages - Outside View by Chirag Mehta

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The Battle of Inflation rages
Apr 20, 2011

So, we're now a part of history, just by witnessing it - India won the Cricket World Cup once again after 28 years!! Nostalgia, Pride, Joy!

As I sat to read the Sunday newspaper, an article amongst the myriad collages of the victorious Team India caught my attention. The report was an interesting piece on the sudden increase in the price of the final match tickets - Tickets that initially were priced at Rs 5,000 suddenly escalated close to a staggering Rs 36,000!

Now this is what we call a real time example of momentary inflation. While the sudden spike in ticket prices is surely because of the temporary sports fervor, we have more unsettling issues at hand, for instance, the challenge of dealing with inflation that has usurped the world at large.

Both developed and developing economies are constantly battling for a solution to the chaos of inflation today. This burden does not only lie on the shoulders of the emerging economies, in fact records show that the mighty US is equally (if not more) troubled. US Consumer Price Index (CPI) has grown from 1.6% in January to 2.1% in February 2011 alone. That's a growth of almost 1.1% as compared to September 2010. In recent months, the CPI less food and energy has also gained momentum and become stronger. As compared to last December and October, the yearly rate of growth rose to 1.1% percent and 0.6% respectively.

The Economics of Grocery Shopping!

Have you visited the vegetable market recently? The prices you paid for a kilo of ripe fresh tomatoes just zoomed to Rs. 50 a kilo! While we sit at home wondering if there are ways to cut costs, others say that this is just the beginning of the inflationary trend and more such shocks lie ahead.

So how did the once Rs. 20 a kilo humble tomatoes suddenly move to Rs. 50 in just 1 year? Here's how...

When the government injects money into the economy, it does not affect the prices of the goods immediately. It slowly and steadily trickles down the economy from one market to the other just like the molten volcanic slag. A study by economist Frank Shostak states that in the US it takes around 36 months for changes in the money supply to have a visible effect on the prices of goods in general.

The study suggests that based on the massive monetary pumping done in the past and with the time lag of 36 months, the growth momentum of the full CPI and the CPI less food and energy is likely to strengthen in the months ahead. The study forecasts a 2.4% rise by September and a further jump to 4.4% by December. The underlying message of the study: there is a growing risk of price inflation accelerating in the months ahead.

The Cause of it All

It all begins with simply misreading a solution! To bail itself out of the financial crisis, the Federal government has been busy pumping massive amounts of money into the US economy. This has led to an increase in the growth momentum of the money supply, making it the key reason for the current rise in price inflation.

A few numbers to better explain: the Fed injected about $2.1 trillion into the system until June 2010, and has additionally supplemented it with a whopping $300 billion. This becomes a cyclical affair and causes price inflation. The money supply indices demonstrate this very clearly. Such an artificial increase in the money supply is in itself termed as "Inflation", and price inflation just happens to be one of the negative outcomes of such a method.

Here are the supporting data to prove that the government has been pushing money into the system...
Source:Federal Reserve Bank of St. Louis

Bernanke's Rationale

Ben Bernanke, the current Chairman of the United States Federal Reserve, said he "artificially altered" the system to stimulate housing and employment. The unemployment rate did slightly fall in recent months, but most market analysts fear that what's shown through statistics in a boardroom does not necessarily bring about improvement in the real world.

The Economy mirrors the flaws

US citizens have witnessed the price of just about everything skyrocketing. Due to the US government's focus on housing and unemployment, only housing, the dollar currency and inflation-adjusted income are negative, while world food and commodity prices have risen by 28% over the last 6 months.

But, even though the Fed wanted to lift housing prices and restimulate the entire real-estate sector, housing prices are still falling, and new home construction just crashed at the fastest rate in 27 years.

So what has really been stimulated? Stock Prices, sure! But, stock prices are not real wealth. People tend to believe that the rise in stock prices is good news.... but this is one of the most flawed economic notions. The expansion of paper money and credit simply gives a sense of exuberance, an economic high that leads to excessive risk taking and creation of unsustainable bubbles.

When new money is pumped into the economy, it re-inflates the old bubbles and creates new ones. Most importantly, Quantitative Easing (QE) facilitates government deficit spending and creates unrepairable distortions in the economy. It also leads to malinvestments and is actually a waste of scarce resources.

Money printing cannot make society richer; it does not produce more real goods. It has a redistributive effect in favor of those who receive the new money first and to the detriment of those who receive it last. The money injection in a specific part of the economy distorts production. Thus, QE does not bring ease to the economy. To the contrary, QE makes the recession longer and harsher.

What lies ahead

The US Fed has become like the mother hen of all economic problems that their economy needs to deal with. A small shake here and there, all financial institutions run for cover to the Fed. While the QE I supported struggling banks during the recession, by buying their bad assets, the mother hen again took them under her wings by supporting the government's policies.

The Fed has two choices ahead: more stimulus or fiscal sobriety. Stimulus is like drugs, it takes more of the drug to get the same effect. And the more addicted you get to it, the more vulnerable you become. Each new dose makes the person ever less rational, ever more incoherent.

After QE II, can we expect more QE's - QE III, QE (n)?

During an interview, when asked if there's a possibility of committing more than $600 billion incase the economy looks bleak, Bernanke replied, "Oh, it's certainly possible," he said. "And again, it depends on the efficacy of the program. It depends on inflation. And finally it depends on how the economy looks."

This clearly indicates the possibility that the Federal Reserve will purchase more government bonds and also implies that Bernanke thinks that inflation and QE are two different concepts.

So how long would these extraordinary emergency measures be maintained? In March 2009, Ben Bernanke stated that the Fed had an exit strategy from its emergency credit policies. The Fed would simply undo its credit policies and asset purchases, thereby reducing the size of its balance sheet to its pre-crisis level.

Such an easy exit option does not exist. A few points to note:
  • Although the Fed purchased the problematic assets, it did not help solve the real underlying problems in their economy.

  • Just by injecting new money into the economy, you cannot expect malinvestments to go away.

  • If the Fed keeps bailing out and helping financial institutions, necessary liquidations and readjustments will only get delayed.

Will there be a QE III?

Going by what Bernanke said it looks extremely likely: "In the end, we'll just ask the same questions. Where's the economy going, and what do various inflation indicators look like? We'll ask those questions. If unemployment is still too high, then we may continue. If we're moving towards full employment, then we won't need to stimulate more".

And what is full employment? The Fed's statisticians believe that full employment is an unemployment rate of approximately 6%. However, given the current state, they are nowhere close to reaching those figures soon.

Let Gold protect you

We have been trying to explain why we feel that QE is a flawed and dangerous policy that is built on unsound principles. It's almost like stimulating a zombie with fiat money, and hoping that it will start to live and breathe on its own.

As expected, the US economy is showing some improvement after a huge monetary injection. But, the adverse effects are also seen in the inflation numbers. These two reasons would likely enforce a pause, albeit short-lived, to the Quantitative Easing policies embarked on by the Fed.

As time wanes and the effect of new money creation starts diminishing, the Fed would soon get on board with its ammunition by doling out huge sums of money into the economy in a rejuvenation effort.

In times like these, investors would do well to buy Gold before the inflation demon makes things worse. There is also a possibility that the short-lived pause mentioned above may bring about a decline in gold prices. During this time, you would witness much hype about gold prices peaking and the so called misunderstood "end of the gold bull run". We would recommend that investors keep allocating to gold systematically and if any such deadline materializes at all, then to make use of any such opportunities to buy for the long term.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.


The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.

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