Conceptually Fragile
Inflation!
Financial markets worry about inflation. Fears of future price increases
can cause stocks, bonds, and currencies to gyrate wildly. But measured inflation
rests on a conceptually fragile foundation, and one that is highly likely to be
redefined by the Government agencies responsible for the calculations within the
next few years. Investors should augment their inflation outlook with an
understanding of the impact of global bond managers on the markets. The momentum
that results from their changing outlook is fast becoming one of the major
factors in bond market movements.
Poor Overburdened Inflation
Inflation is a central and crucial concept in
financial markets, as well as, economic life. However, the role it plays is far
greater than it deserves. Our most cherished notions of modern finance and
investment involve the concept of inflation, yet this tired and worn statistic
is increasingly being challenged. We review some of the inflation "truths"
below:
- Inflationary Expectations Drive Monetary Policy. One of the
dominant tenets of economic analysis is that inflation is a direct function of
economic growth, particularly as the economy approaches full capacity. Stronger
demand for goods and services, it is said, give suppliers the opportunity to
raise prices. Following this belief, central bankers attempt to achieve their
objective of sound money by regulating economic activity through control of
short term interest rates. For example, in early 1994, the US Federal Reserve
made a "pre-emptive strike" against future inflation, raising short
term interest rates by 3% over the next twelve months. Conversely, low measured
inflation rates have recently allowed the Bank of Canada to pursue a very
stimulative monetary policy.
- The "Real" Rate Concept. The most common method of
attempting to understand long term interest rates is to view these rates as made
up of two components: "real" interest rates,
plus the rate of projected inflation. A cursory reading of post-war financial
market history showed many observers in the mid-1970s, when inflation began to
be problematic, that the level of rates could be disaggregated into the measured
inflation rate, and a relatively stable component they called "real"
since it was determined by the demand and supply of capital for "real"
economic factors, like capital spending. In this theoretical model of rate
determination, "real" rates fluctuate between 2% and 4%, and average
3% over the economic cycle. Nominal interest rates should be the sum of
anticipated inflation and the "real" component. Thus, Government of
Canada bond yields today should be roughly 5%. This is comprised of 2% for
inflation, and 3% for the "real" activity. That interest rates are
currently 6.75% is an anomaly that many investors view as a great opportunity to
lock in historically high rates.
- Corporate Finance. In corporate financial theory, although more
loosely used in practice, business plans for expansion are always taken after
assessing the cost of capital. If financing a project is more expensive than the
expected return, no businessman would undertake the enterprise without support
from the appropriate government purse. Both sides of the business decision
embody assumptions about future inflation rates - their ability to price the
product in the future and the cost of capital - which is a function of interest
rates, and thus, linked directly to inflation.
- Currency Levels. In this era of globalization, exchange rates are
ever more important in determining flows and prices of goods and services.
Although many forecasters have given up the attempt to project currency values,
those who do most often rely on the concept of Purchasing Power Parity. The
fundamental notion here is that relative changes in the rates of inflation
between various countries should be a primary determinant of exchange rate
movements.
- Stock markets. Perhaps less directly, and less obviously, stock
prices also reflect expectations concerning future inflation, as a key component
of the discount rates applied to expected earnings and dividends in the future.
What is this Thing Called Inflation?
Obviously then, a crucial job for financial market participants is
understanding the factors which determine current, and much more importantly,
future rates of inflation. But, what is this thing called inflation? Inflation
is generally measured as the rate of change in a constructed price index over a
one year period. In the major economies, the typical procedure is to construct a
"basket" purchased by the "average" consumer and adjust the
basket every ten years or so. Over the most recent twelve month period, the
consumer price index (CPI) in Canada has risen approximately 1.4%, hence an
inflation rate of 1.4%. There are substantial difficulties in defining these
variables, with some arbitrary assumptions made along the way, but generally CPI
measures are no worse than most economic estimates. Some of the conceptual
difficulties in creating the basket include how to adjust for quality
improvements, the changing composition of purchases, assumptions regarding rent
or housing, and the role of taxes.
Enter Politics
A political dimension to the inflation puzzle is developing. Most
economists, including both Mr. Greenspan, of the U.S. Federal Reserve, and Mr.
Theissen, of the Bank of Canada, believe that the Consumer Price Indexes are
overstated - by as much as 1.5% in the US, and 0.5% in Canada. This is a crucial
issue.
Future government spending (and therefore future deficits) will be much
lower if inflation is actually lower than current measurement techniques
suggest, since cost of living increases have been built into all social security
programs. A reduction of 1% per year in projected spending on social security
would basically eliminate the likelihood of bankruptcy in the old age support
program. Thus there is substantial political motivation to take the easy route
to spending control by redefining the index.
The conclusion is inescapable - too many aspects of our financial and
economic world depend on a conceptually fragile foundation, and one that is
highly likely to be redefined in the next few years. Faced with these
uncertainties, investors should be working to supplement our traditional
approach to interest rate forecasting with assessment of the variables which
most importantly affect global portfolio flows.
Drivers of Portfolio Decisions: Global Bond Managers
A research consultant that I deal with has demonstrated that price momentum
plays a major role in the performance of world bond markets. His explanation for
this phenomenon is that the traditional economic approach to interest rate
forecasting has proven too imprecise to serve as the dominant tool. Now that it
seems probable that inflation will be redefined to suit its political masters,
investors should be placing more emphasis on the factors most likely to
influence the activities of global portfolio managers. This means increasing the
weight given to political, currency, and economic policy variables in
consideration of whether, and when, the trends extant in the fixed income
markets are about to change. Expected inflation will continue to play a role,
albeit less important, in a forecasting process.
Article by Bob Swan, February 19,
1997 
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