From: O'Neill, Jim [IMD]

Sent: 13 February 2011 13:48

Subject: INFLATION.

   

INFLATION.

The topic I have chose this week is of course worthy of a much longer and more in depth study but it is clearly one that
people are asking about.

Slowly but surely, as we see more and more signs of global recovery with the developed world starting to participate
also, a growing fear of inflation is returning. For some, including experienced economic leaders of the past and today,
there is an inevitability about it. Ex-US Fed Chairman Alan Greenspan would typify this crowd. For many others,
especially those that love to search for so-called black swans under every rock; it is the obvious thing to worry about
once they stop worrying about the risk of depression.

Many current developments add to the growing fear. Rising oil and other energy prices, fresh increases in food and
other agricultural prices, the emergence of a more wealthy, but less cheap China, the pressure to transfer the benefits of
globalization to western workers as opposed to shareholders, an increase in regulation, and of course, the much
discussed fiscal deficits and sovereign debt throughout much of the developed world.

For many economists, however, especially those that have been most active in the era since the early 1980’s, the great
era of inflation control, it is difficult to share this inevitability. Originating with the tough anti-inflationary policies of Paul
Volcker at the Federal Reserve in the US, the widespread introduction of deregulated markets, globalization, and the
introduction of the Internet have all been huge forces to bring the inflation process to where we broadly sit in current
times. In many countries, the advent of Inflation Targeting as the cornerstone of their macro economic policy making
appears to have made it easier to consolidate these gains.

Which view is going to be right? Having started my professional career in 1982 when Paul Volcker appeared on the
scene, I have many sympathies with the optimistic view of the economic forecasting consensus. That being said, I share
some of the concerns held by the “inevitability” crowd. On one level, as with many things, it is actually quite simple. How
can you expect inflation to remain as low as it is, without the risk of deflation? If we aren’t prepared to risk deflation, then
to some extent, a pickup in inflation is inevitable perhaps. It is just a matter of how much.

SOME SIMPLE MISUNDERSTANDINGS.

Before I delve more into the complexities, I want to refute some commonly held views.

First, many believe that true inflation is actually higher than is reported. I have had conversations on this topic virtually
every day this week. The strong rise in many food and energy prices is cited as clear evidence that this is true. It is cited
about Chinese inflation, and in many more advanced economies. While it is inevitable that, at any one point in time,
reported consumer price indices won’t be as accurate as they should be, the idea that there is some deliberate
manipulation of the official data accuracy doesn’t really stand up. If inflation is so under-reported, then why does it not
show up in inflation expectations surveys when people are actually asked?

Second, linked to the above, sharp increases in commodity prices are not in themselves inflationary. They are simply
relative price changes. It is true historically that sharp increases in commodity prices were typically associated with
periods of rising inflation. It is also true (more below) that sharply rising commodity prices create a bigger dilemma for
lower income economies. However, for all those prices that are rising, many others are not. The purchase price of many
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electronic goods has declined in recent years, and some are still declining like mobile telephones, personal computers,
etc. These relative price moves happen all the time and do not necessarily signal an inflationary period. Indeed, a true
inflation period develops when many prices start to rise together, including the costs of employing people.

The third common view is that inflation is always a monetary phenomenon. The dramatic expansion of central bank
balance sheets in many Western economies and their large fiscal deficits make a rise in inflation seem inevitable to
those who hold this view. A subtle part of this view is that it will be difficult for policymakers in a challenged democratic
society to exit from past monetary and fiscal excesses even when economic conditions improve. As far as non-
developed economies are concerned, it is seen that they are still so dependent on the West that they ultimately have
little control over their own inflation rates. Of course, some concede that China is exempt from this belief, but it is
“inevitable” that China’s loose monetary policy and vast accumulation of foreign exchange controls will result in inflation.

Time will tell whether this third common view will be come reality. And, of course, it will depend on many economic
forces in many economies and “exit” policies from central banks. But while, by definition, inflation might ultimately be a
monetary phenomenon, using any measure of monetary growth as a reliable guide to future inflation became a lost
science in the 1980’s. In order for any monetary variable to be reliable, the so-called “velocity” of money in circulation
needs to be stable, which is not often the case.

INFLATION IN THE (INAPPROPIATELY NAMED) EMERGING WORLD.

The recent rise in reported inflation in many important emerging economies, especially those that we refer to as “Growth
Markets” is a tricky issue. In each of Brazil, China and India, rising inflation is an issue, and the future domestic demand
performance of these economies is not only important for them, but also for the rest of us, as I have argued on many
occasions. If inflation were to rise sharply in these economies, resulting in either (or both) a dramatic decline in local real
incomes or severe monetary policy tightening, it is quite conceivable that their economies would slow down sharply.

CHINESE INFLATION.

At the core of the Growth Market world is China. It has become very fashionable to believe that Chinese inflation has
started a period of acceleration and that policymakers are “behind the curve”. This is a very important issue and inflation
evidence in coming months is going to be critical to watch. If China is to be successful in transferring the impetus for
growth away from exports (and investment) to domestic consumption, it is very important that inflation does not raise
sharply eroding real income gains for its citizens. While the central bank doesn’t enjoy independence in anything like the
style of many other nations, it does have an important role to play, and it has an inflation target. For much of the recent
past, that target has been 2-4 pct, and inflation is currently above the higher end of this range. In fact, the December CPI
rose by 4.6 pct, down from November’s move of above 5 pct. This week, we are expecting a fresh move back above 5
pct. With commodity prices so buoyant, especially food prices, many expect inflation to rise above 7 pct in the second
half of 2011.

Two interesting things happened last week ahead of the next CPI release. First of all, China hiked official interest rates
again the day before the end of the annual New Year holidays finished, which could be read as a deliberate signal to
everyone that they are trying to clamp down on many forms of excess, especially those that relate to inflation. It would
also seem to me that authorities are much more prepared to accept continued appreciation of the RMB in coming
weeks. A stronger currency gives some support to trying to control the local cost of rising imported commodities. The
second thing that happened is that the stock market – unlike others in Asia – rose on the last two days of last week.
China is now showing a small rise for 2011, so far unlike many other BRIC, N11 and exotic markets.

I don’t share the new popular concerns about Chinese inflation. I do think it is an extremely important issue. The reason
why I am less concerned is twofold. Firstly, as discussed, it makes it much more likely that policymakers will allow further
RMB appreciation (assuming Washington and others don’t embarrass them too much with public demands). Secondly,
and more importantly, lead indicators suggest that policymakers are not in fact behind the curve. If you look at both the
GS Financial Conditions Index (FCI) for China and its proprietary lead economic indicator, both suggest that momentum
of the economy will slow. So while Chinese inflation has risen above the top end of the PBOC’s target, it is far from clear
to me why this will persist.

INFLATION ELSEWHERE.

I have more confidence in anti-inflation policy in China than elsewhere. It seems to me as though Chinese policymakers
show a more pre-emptive tendency. It is less clear in many other countries; especially some where political figures
sometimes claim that their economies have rising growth potential. Brazil, India, Indonesia are just three that I would cite
in this regard. Nonetheless, having said that, policy has been tightened in many of these economies also recently, and
while there are some possible exceptions, policymakers are doing the sort of things that they generally should do.

It is also interesting that the growing evidence of a recovery in the US, the associated re-pricing of US interest rate
markets, and the apparent signs of asset allocation away from many emerging markets, concerns about excessive
capital inflows in many of these economies may recede. It may also mean that local policymakers switch from trying to
control excessive currency appreciation to measures that support their currencies.
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 In the developed world, it is also becoming more fashionable to focus on the “inevitability” of rising inflation. I will offer a
brief comment on each of Japan, the Euro Area, the US and the UK.

As far as Japan is concerned, quite simply, some positive inflation would be surely welcome by anyone other than bond
holders, as of course, Japan has been facing more fresh deflationary pressures than anyone else. While the Bank of
Japan is very reluctant to officially embrace a modest positive CPI “target,” I am sure it would be delighted if it happened.

In the US, to some extent the same is true. As Chairman Ben Bernanke has made clear, the Fed has been unhappy with
inflation dropping below 2 pct. They would generally like core inflation to be around 2 pct or perhaps a bit less. While
markets have removed the risk of deflation out of their pricing structures, most useful measures of inflation expectations
show little sign of a notable pick up. In fact, they remain remarkable for their stability.

The Euro Area is, as with many things, more complex. In a booming Germany, not surprisingly, there are worries about
inflation. The complication arises because the ECB has a stated mandate to keep inflation around “just below 2 pct.”
Given the deflationary forces at work in some of the peripheral economies, if the ECB is to achieve its mandate, we may
face a period where German inflation in the 3 pct vicinity might actually be necessary. Needless to say, it is very difficult
for many policymakers and citizens of Germany to accept this simple mathematical reality of being a member of
European Monetary Union (EMU), but this is another possible dilemma looming.

This brings me to the UK. Of all the so-called advanced countries that I think about regularly, the UK is perhaps the
trickiest. Despite the imminent fiscal tightening and much despondency about the economy, inflation has persisted
above the Bank of England’s CPI target for now some time (and unlike other economies, there is another index that is
well known and used for some wage setting, that is rising even more). In addition, there are some signs of modest
increases in inflation expectations. All of this despite the mood that UK banks don’t lend and monetary growth is not
capable of generating inflation. While some at the Bank appear to be changing their relaxed stance about the inflation
outlook, the implied message from last week’s MPC meeting was that the majority is not worried. I am not sure that I
would agree with them. And, it seems that markets have now priced for some “pre-emptive “UK rate moves. This might
not be an entirely insane idea for a central bank that needs to keep its credibility. It is certainly not a straightforward
choice. Forthcoming data about the momentum of the economy, as well as anecdotes about the inflation process, are
likely to be keenly watched ahead of the next meeting.

INFLATION AND THE MARKETS.

Against this background, there is an interesting “Long View” from John Authers in this weekend’s Financial Times.
Discussing two recently published studies on the long term performance of bonds relative to equities, he reflects on the
fact that in the past decade, bonds actually outperformed equities. He also writes that since 1982, the year I entered the
financial markets, the average annual return on long-dated bonds compared to short-dated bonds is around 5.2 pct. He
also reminds us that since 1900, it is a much paltrier 0.8 pct.

What happens to actual inflation and inflation expectations in coming months will remain as critical as it has been over
the 29 years since Paul Volcker worked his magic. If the “inevitable” crowd turns out to be right, you know what is
coming. As I said earlier, if we are to avoid deflation, which I believe we have, some rise in inflation seems pretty
obvious. But I don’t see any inevitability about it being much.

What I would leave you with, however, is two things. I am sufficiently convinced about the global and US economic
recoveries that bond markets need to further re-price themselves with high real yields. Together with the risks that
policymakers might overstay their friendliness, government bonds remain a risky place to be in 2011, certainly relative to
equities.

The final thing relates to my usual obsession. While the blue half of Manchester seems to be undertaking policies to
support the inflationary process, it seems that after this weekend’s results, they are unlikely to generate the second
round effects that are necessary to complete it!

I will not be writing a Viewpoint next weekend as I am taking a brief vacation,

 
Jim O’Neill
Chairman, Goldman Sachs Asset Management

  
Viewpoints are also available on our website.
 
 
 

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 Jim O’Neill is the Chairman of GSAM, which is a separate operating division and not part of the Global Investment Research 
(GIR) Department. The views expressed herein by Mr. O’Neill do not constitute research, investment advice or trade 
recommendations and may not represent the views and/or opinions of GSAM’s portfolio management teams and/or the 
GIR Department. Copyright © 2011 Goldman Sachs. All rights reserved. Please visit our website for additional disclosures. 

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