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quigleydoor
09-29-11, 05:11 PM
Interesting article on inflation from RiskCenter today:


September 29: Commentary - Reaction to Dangerously Rising Inflation

Location: London
Author: Dr Arjuna Sittampalam
Date: Thursday, September 29, 2011

Rising inflation is a fact of life worldwide. More ominously, some authorities in the developed world are signalling that some inflation would help to get their economies out of the public debt hole, as happened after the Second World War.

US commentators in particular are pointing to the anchoring of inflation expectations as a reason for not worrying. Many are not convinced. More tellingly, the all-important issue of accounting in the presence of inflation is being resurrected. It was debated in the ‘70s, but has been largely dormant since.

Anchoring inflationary expectations – how firm?

How likely is it that inflation would provide a solution to the debt overhang? With countries representing more than 60% of the world’s GDP, including the USA, Europe and Japan, all in a deep public debt hole, the chances of inflation being thought of as a way out are definitely not low. The Wall Street Journal writer Holman Jenkins points out that the hyperinflation in the Weimar Republic period in Germany, and in Peru and Zimbabwe, was not caused by the central bankers setting out to become hyper-inflationists. They had to choose between anarchy and printing money. Liaquat Ahmed’s prize-winning book refers to Rudolph Havenstein, during the Weimar regime, having taken pride in executing hyperinflation well.

The Federal Reserve Chairman Ben Bernanke’s mantra is that US inflation is under control with so much unemployment and unutilised capacity. More importantly, he and other Fed officials point to the anchoring of inflation expectations, which means the confidence that companies, consumers, workers and investors have in central banks keeping the lid on rising prices.

The theory is that, if everybody expects rising prices and wages, it will happen, but also, conversely, that the global spike in commodity prices etc. will not feed through into sustained rises in inflation if it is widely believed that the Fed will clamp down on it.

The idea of controlling inflation expectations was not around 50 years ago, when it was assumed that historical inflation would continue, but now it is an important tool in central banks’ armoury, and measuring it is crucial, although obviously this cannot be done with any accuracy.

In the USA, in a quarterly survey of professional forecasters, the Fed in Philadelphia found that inflation is expected to be only 2.3% over the next ten years, somewhat below their forecasts over the last ten. On the other hand, a University of Michigan/Reuters survey of consumers found that, although they are more bearish over the next 12 months, their five to ten year outlook remains stable at 2.9% per annum Another indicator that the Fed watches like a hawk is the gap between conventional US Treasury Bonds and the inflation-protected variety. The difference is taken as inflation expectations, although this is not reliable, because supply and demand and liquidity issues can distort the difference from time to time.

Critics argue that, while the Fed might have credibility now, this anchoring will only last as long as its credibility survives. It is suggested that it may have been just lucky, in not having had to cope in the past few decades with the type of big inflationary oil price shock seen in the ‘70s.

Goldman Sachs’ Chief US Economist, Jan Hatzius, is among those who actually subscribe to the Fed’s stance on anchoring. In an interview with Tom Keene of Bloomberg Businessweek, he suggested that the USA has had a longer period of anchoring domestic inflation expectations since the ‘80s than Europe as a whole, and that this explains why the European Central Bank felt compelled to increase rates recently while the Fed remained more relaxed. He noted, however, that Germany’s anti-inflation record has had an even longer period than the USA’s.

Equities – inflation’s deadly accounting threat

Inflation is supposed to benefit equities, but the reality is that it poses a major threat because of accounting issues. The theory is that earnings and dividends keep up with inflation. But there are key factors that upset this cosy picture, mainly because of the interaction between accounting output and the tax system.

Depreciation is one of the major problems. For accounting and tax reasons, companies depreciate at rates based on the prices they actually paid for capital items, and declared earnings and profits are calculated after deducting this historic depreciation rate. But, when inflation has been significant for a few years, the company has to pay out much more to replace the asset, which is not reflected in the historic figures declared. So earnings and profits are heavily overstated in real terms, with falls in free cash flow squeezing real dividend payment capacity, the actual dividends effectively paid being out of capital.

A similar problem arises with stocks. Profit is struck after the cost of materials consumed over the year, but during high inflation the replacement cost of these materials is actually significantly higher, leading to the same effect as depreciation.

These problems were rife in the ‘70s. At one stage UK consumer price inflation was around 25% per annum, but industrial cost inflation was nearly double that, at 50%. The government had to hastily introduce stock appreciation relief, to avoid companies being taxed on non-existent profits and driven bankrupt. Unsurprisingly, share prices nose-dived.

Currently, US and international accounting standards require the use of inflation accounting to be used by companies that have divisions in hyperinflation countries, hyperinflation being defined as 100% over three years or 26% per annum compound. This 100% rate currently captures only Venezuela in its net, but India and Russia, with three year rolling figures exceeding 30%, might possibly be in the danger category unless firm action is taken.

Accounting for inflation effects becomes essential when the danger of high inflation rears its ugly head, as might be the case currently. Already there are mutterings in the accounting world about inflation accounting, with the International Accounting Standards Board expected to consult on inflation accounting in the next 12 months.

The accounting solution is obviously to index capital expenditure and stocks. But the problem here is which index to use, given that inflation in company costs is, as mentioned above, markedly different from the behaviour of the consumer price index. In the ‘70s, substantial debate took place in Britain over this issue and, by the time an agreed standard was formulated, inflation had already died down anyway. One major problem is that accountants prefer objective historic figures to subjective inflation adjustments, and many company executives would not mind publishing spurious profits either, if it made them look good.

A continuance of significant or rising inflation poses a serious short-term threat to equity prices in addition to the doubt surrounding long-term prospects. The paradigm that equities will always come right in the long-term has been challenged by leading academic research. As mentioned in a previous EDHEC-Risk article drawn from Investment Management Review, “the already substantial evidence against the paradigm that ‘equities are a good bet for the long term’ has been reinforced by the latest academic studies.---------- Though equities have rallied over the last two years, stocks can still fall for long periods. For instance, from 1910 to 1948, stocks outside the US had a cumulative negative return of 3% pa.”

Conclusion

The Fed’s optimism about inflationary expectations might have been more credible if it had not been accompanied over the last ten months by several Fed officials, including Bernanke himself, publicly toying with the idea of some inflation. The Bank of England is also believed to be tolerating, or even preferring, at least some modest inflation, perhaps under pressure from the UK Government, which is throwing into doubt its much-vaunted independence. The fashionable idea of ‘financial repression’ does not assist the anchoring of inflation.

History shows that, should inflation rates spike up past 5% in the developed countries, the authorities might be faced with an ugly choice between a vicious wage-price spiral and clamping down. In other words, a figure significantly above 5% might not be a stable level. So far, it has still to reach these seriously worrying levels and the jury is still out as to whether the muddling through will work.

Clearly, bonds with payments fixed in nominal terms lose out with inflation. But, if inflation starts taking off, equities could also become a major short-term casualty, in view of the accounting issue above. Given that the long-term as well is not that bright, anybody who fears inflation now needs to think twice before going into equities, unless it is a company with particularly good anti-inflation credentials.

In the last decade of high western inflation in the ‘70s, securities markets performed poorly but the investment management industry, in its relative infancy, was less affected. This time around, if inflation does take off, the industry, much more mature and already fragile and suffering from over- capacity, could be badly hit.

Author: Dr Arjuna Sittampalam, Research Associate with EDHEC-Risk Institute and Editor, Investment Management Review

References

"EconoChat," Tom Keene, Bloomberg Businessweek, 18.04.11
"The pitfalls of Tinker Bell economics," David Wessel, the Wall Street Journal, 24.02.01
"The inflation solution," Holman W. Jenkins Jr., the Wall Street Journal, 07.04.11
"Inflation’s distorting effect on results needs tackling," Tony Jackson, Financial Times, 11.04.11
"Inflation hedge podge," The Lex Column, Financial Times, 05.04.11
"A long-term conundrum for equity investment," Investment Management Review, Spring 2011 (www.imrmagazine.com, enquiries@sageandhermes.com)


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