Inflation and deflation are likely to be the joint themes for 2011,and UK economic growth is revised down

After talking about a Santa Rally for equities yesterday we saw several equity indices go to new highs for 2010. For example the UK FTSE 100 touched 5958 and the German Dax touched 7088 giving annual returns of 13% and 19%. Indeed if we go back to the falls of the credit crunch period we have now seen some extraordinary rallies. For example the American S&P 500 hit a closing peak  of 1565.15 on October 9th 2007 and then fell to a closing low of 676.53 on March 9th 2009 for a fall of 56.8%. However the rally up until now taking it to 1254.6 represents a rise of 85.4%. Indeed this rally seems able to ignore all the bad news from places like the Euro zone and just carries on regardless.

Commodity Price Inflation

This continues to be a theme of 2010 and it is true to say that in the latter part of 2010 equity market rallies have been accompanied by commodity price rises. The Commodity Research Bureau’s spot index of commodity prices rose to 511.5 yesterday with all of its sub-components rising. As this index was at 420 some 6 months ago then there has been an increase of 21.6% since then which is worrying for inflationary trends.

Various metals and foods have hit the headlines during 2010 with fears over wheat and corn harvests and metal prices being strong. Yesterday it was the turn of sugar and coffee to hit highs and headlines. For example the futures contract for raw sugar hit a 30 year high at 33.5 cents per pound and somewhat bizarrely there were reports that Portugal had run out of sugar last week in another triumph of European central planning (and yes it did come with an official claiming this should not be happening in a eerie echo of the financial crisis!) The futures contract for Arabica coffee hit a 13 and a half-year high at US $ 2.2695 per pound. The latest metal to have a price surge is copper which is now priced at US $425.2 per tonne which is up some 26% since the beginning of September.

We are also seeing strength in the price of crude oil as the price of a barrel of West Texas Intermediate grade crude is now US $90.20. This represents a rise of some 21% in 2010 but this does not represent the scale of the recent acceleration as we had falls earlier in the year and the price is up some 26% since the beginning of September. Linking equity markets to crude oil then courtesy of the Financial Times I have just been comparing the S&P 500 to the crude oil price in 2010 gives an interestingly similar pattern. This reminds me of my comments earlier in the year of how difficult it is to get any investment diversification in these times.

So it looks as though 2010 with one of its themes of commodity price rises leading to inflationary trends as strong as ever.

UK energy prices and institutionalised inflation

A problem in the UK is the way that many of our prices are set by institutions who feel that they can raise prices with impunity and sadly they are often correct in this. However in our current cold snap where our energy supply resources and infrastructure are being tested I though I would give you a counterpoint to the usual cry for higher prices that come from our mostly foreign-owned oligopolies.

The price for natural gas on the Nymex futures exchange in New York is currently US $4.07 per therm.The high for the year was US $6.07 back in January so as you can see this is an area where there has been an increase in supply due to higher prices leading to a fall in the price, or perhaps capitalism at work. In fact prices are at a five-year low. So whilst there may be supply issues for getting enough gas to the UK there is in world terms no particular shortage and no reason for a rise in price. Sadly for those who rely on heating oil there has been a rise in the price of around 28% in 2010 so there is more justification for price rises here.

More Problems in the Euro zone

I expect 2011 to be a year where inflationary trends of the sort I have discussed above are combined with deflationary trends. Plainly the peripheral nations in the Euro zone are an example of a deflationary influence with Greece and Ireland clear example of this and Portugal is in a situation where she too is in an unsustainable position. I reported yesterday about the rather self-fulfilling nature of the Moodys report which was something along the lines of  Be afraid. Be very afraid. There was some hope as China appeared to promise to buy some of Portugal’s bonds but the truth is that China keeps making such promises and we have yet to see action on this front. With China’s surpluses she could easily save Portugal and the yield is much higher than from her usual investment of US Treasury Bonds but she too must be concerned about possible default.


The last couple of days have seen something rather disturbing happen in Ireland’s situation as her ten-year government bond yield has surged above the levels seen when she called in the EU/ECB/IMF troika. This has echoes of what happened with Greece.  The ten-year closed at a yield of 8.89% last night. One factor which is again troubling investors is this which I mentioned on the 20th.

4. There remains talk of derivative losses sitting on the books of the Irish banks and this needs to be addressed apart from having echoes of AIG/Lehman Bros from 2008.

Investors have looked at the agreement between Ireland and the troika and spotted that the liability for any such losses seems to now reside with the Irish nation. Added to this Allied Irish Bank placed more than 9 billion Euros with the bad bank Nama leading the blogger Jagdip Singh who has a good track record to question if AIB is solvent. So we are back to Ireland being under pressure and at this moment the rescue plan looks as likely to suceed as the one for Greece.

Other Euro zone nations: Contagion for Spain and Italy

These two nations have become increasingly affected by the contagion effects of what has happened in Ireland and Greece and what looks likely to happen in Portugal. We can illustrate this by looking a their respective ten-year government bond yields and comparing them with a month ago and if we do this we get for Spain 5.55% and 4.74% and for Italy 4.71% and 4.21%. As I type this these are problems but not a crisis as whilst Spain has recently had to issue some shorter-dated paper at a higher cost than before this is so far relatively small fry. You see in 2011 both nations have quite a lot of debt to issue both to finance their deficits and to replace existing debt. Indeed we will see this start in January and if you start issuing substantial amounts of debt at higher interest-rates, then your solvency arithmetic can change quite quickly. One of the flaws of the Euro zone rescue system is that it will be issuing debt too so there is the danger of it crowding out sovereign nations.

If we look at the recent effort by the European Central Bank with its Securities Markets Programme to buy debt in Ireland Greece and Portugal to try to prevent contagion we can see that at best it is only delaying the spread. As I wrote when the SMP was beefed up after the ECB meeting earlier this month this particular phase may have been tactically astute but it was also strategically unsound. The recent plan for an addition to the ECB’s capital was rather eloquent on this subject I thought.

The UK’s economic growth in the third quarter

This morning this has been revised down from 0.8% to 0.7% in terms of growth in our Gross Domestic Product. This is well within the margin of error and accordingly is a shame (as we need every scrap of growth we can get) but is not particularly significant. Even with this slight downgrade our economy grew by 2.7% over the past year which if we went back a year and asked people they would have been very happy with. However linking this news with yesterdays disappointing fiscal deficit figures only reinforces how disappointing they were.

There had been a lot of debate over the construction figures which had shown extraordinary growth. In the event they were only revised down from 4% to 3.9%. However sneaked away in the detail was an update to growth for the construction industry in the second quarter where it was cut from 9.5% to 7%. Partly because of this economic growth for this quarter was revised down from 1.2% to 1.1%.

Austerity versus Stimulus

This was one of the debates/themes of 2010 and over the past few days I have been revisiting it. For many places I have come to the conclusion that it was not as important as it has been represented. For example if we look at Ireland it looks as though the collapse of her banking sector would have derailed any economic strategy. So my point is not that it was not an issue but that in fact economic policy is sometimes less significant than we would like to believe. I would be interested to hear others thoughts on this subject.


9 thoughts on “Inflation and deflation are likely to be the joint themes for 2011,and UK economic growth is revised down

  1. By economic policy, do you mean government spending and taxation? I think these are very important, but my understanding is that there are three other important factors: the position in the credit cycle, monetary policy (which is related to, and somewhat responsible for the credit cycle) and resource supply, especially energy. The last factor has a large impact on commodity prices, which inititally seem to have inflationary effects, but actually end up causing a contraction in economic activity. It often appears to me that by concentrating on backwards looking price measures, central banks tighten monetary policy at just the wrong time – i.e. at the moment there is pressure to tighten as commodity price rises (especially oil, which is essential for all transport, costruction etc.) feed through to RPI/CPI inflation, when in fact this is more likely to presage stagflationary recession. Or have I put two and two together and come up with five?

  2. I think you are right, the sheer magnitude of public and private(ish) debt is too much to roll over and austerity measures alone simply are not enough.However post haircut/default many sovereigns may be unable to access markets have to spend within the tax take,so you may as well make a start in imposing fiscal discipline.

  3. I’d be interested to know your thoughts on the difference in policy between the UK/US QE method and the EU method of hard money. Do you think they result in different outcomes at the end of the road or does it simply result in the same level of output but a different set of losers?

  4. Hi Shaun, your very title today “Inflation and deflation are likely to be the joint themes for 2011,and UK economic growth is revised down” is I feel contentious.

    I do not believe that it is possible to have both inflation and deflation existing in any economic system at the same time. This would be algebraically like claiming that a number may be both positive and negative at the same time! That is clearly impossible in terms of fundamental mathematical definitions, and completely ludicrous. I suspect that this “problem” in economics has only arisen due to neo-economists attempting (unsuccessfully I feel) to redefine what inflation actually is, and as a result indulging in a completely muddled thinking approach? What they really mean is that it seems to be possible in terms of their muddled view to have deflation (economic contraction) at the same time as consumer prices seem to be rising. If one takes the classical definition of inflation and deflation it is not possible to have both at the same time in any economic system.

    In my view this demonstrates exactly how the present confusion over fundamental economic terms due to the laxity and fallacy of neo-economists has now resulted in an inability to quantify real economic scenarios. Consumer prices rising does not actually correlate with classical “inflation” per se, and therein lies the delusion. There are many disparate reasons that consumer prices may rise, or fall. They are not necessarily related to inflation at all. To make the assumption that any rise or fall in consumer prices is identical to a rise in inflation or a change in deflation is an error which is completely and totally unacceptable and fallacious.

    Austerity v stimulus is a similar argument. One is algebraically and mathematically the converse of the other. The neo-Keynesianists will argue that “stimulus” is necessary; but to them, because of the political consequences of following through with the real Keynesian policy of retrenchment (exit strategy) they will also neglect that, and accept the effects of destruction of the real wealth creating processes which result from their debauchment. They thus neglect any exit strategy and accept the inflationary consequences. Austerity on the other hand means honesty and truth; aiming at a truly balanced budget in the medium term.

    In any democracy, where politicians need to be re-elected, they always without exception shy away from true Austerity in the end. Austerity does not buy votes but loses votes! Spending more public money almost always buys votes. We should perhaps all read again Shaw’s brilliant works “The Apple Cart” and “Back to Methuselah” (particularly Act III of the latter).

  5. Hi Dfr

    You’ll have to forgive my economic naivety, but wouldn’t fuel inflation create deflation in say the transport sector? But then on the other hand show growth in the oil equity market? Isn’t this an example of both inflation and deflation existing in an economic system? They seem to be antagonistically related to me.

    Futhermore, your comments on austerity have a neo-neoplatonist feel about them, in that as humble director of a company that makes things (alas a dying breed due to the austerity measures of brainless PLC’s, and large pension fund operators that have shifted empolyment to the very Keynesian non democratic peoples republic of China) i cannot see the advantage of making people stop spending.

  6. Hi Friedman, I think the answer is that it depends upon how you define inflation and deflation. That was the point which I was intending to make. Shaun and others now use the term “disinflation” partly to attempt to describe situations like the one you suggest I think.

    The reality is that if fuel for road transport increases in cost in our economy (which is usually partly due to our continuously weakening currency) that will increase the cost of transport, once the transport industry can no longer absorb the increase in cost without increasing its prices. Where there is a fixed money supply in a fiat currency economic system, then that increase in transport cost would not be inflationary; it would thus result in the same spending on transport purchasing less service, However, in any system where the central bank or government increases the amount of fiat currency in circulation to prevent the real price of transport rising, then that increase in cost would seem to be inflationary; it would have precipitated a debasement of the fiat currency which is classical inflation. This is why this phenomenon is known as “cost push inflation”. In classical terms there is no question of “deflation” in the original scenario if the money supply remains the same.

    You conclude that a rise in the price of oil represents “growth” in the oil equity market. Again it depends upon what you define as “growth”. Real growth cannot be measured by price alone in any fiat currency economic system where the money supply is not controlled. It is meaningless. If you use conflicting “units” of measurement you will obtain conflicting and meaningless results. If you use the same real units here there is no real growth in the scenario which you present. The volume of real economic activity has remained the same.

    As you observe, there is not normally any advantage in stopping people spending. However, when there has been too much spending out of supposed wealth which does not exist or is borrowed, then there always comes a day of reckoning when spending must stop, not because spending is not good, but because the real wealth to sustain it is not there. It was thus convenient for Western governments to facilitate circumstances in which most manufacturing was lost to the far East, and to use a credit bubble and temporary mineral extraction to give the semblance of an economic boom in the West; it was suicidal short-termism taken to the extreme.

    The issue comes back to what is taken in any economic system to be the controlling parameter. In neo-economics full or near-full employment is taken as the overriding parameter, whereas in the Austrian school it is sound money. Full employment can be achieved only by generating continuous inflation to maintain it despite rising wages and costs. In classical economic theory, continuous inflation will escalate, eventually probably leading to hyperinflation, having destroyed much of the real wealth creating processes. That is what we are seeing the potential start of now.

  7. Drf,
    Asking a question about your Austerity v Stimulus equation. Wouldn’t it depend on what the ‘stimulus’ was spent on? If we had spent QE on commercial and associated infrastructure and applied direct SME lending wouldn’t take out the worst effects of recession for a period while improving the chances and timeframe for business to come back organically thereby repaying that ‘stimulus’?

    Austerity seems to be having the effects of large companies stockpiling cash reserves, cutting staff, cutting R&D budgets and the bankers calling the political tune.

    • Hi Mac, in the long term I do not believe it will make any difference what any artificial “stimulus” value is spent on. All artificial stimulus will be ultimately inflationary unless the value of the stimulus is subsequently redeemed (with an exit strategy), or it leads to a real corresponding increase in wealth creation. That is of course exactly what Keynes defined; but politically, redemption for artificial stimulus afterwards is anathema, so that always becomes neglected and forgotten! After a while of course the effect of artificial stimulus dies out, and the inflation caused does real economic damage to the wealth creation process, thus making things worse than they were before it. However, at least some votes have been acquired!

      I agree that if artificial stimulus is directed to real wealth generating enterprises, rather than wasted on subsidising bankster’s bonuses, the effect for the general economy would be much better. However, it would still be inflationary unless accompanied by a resultant increase in real wealth. My belief is that the only real economic stimulus which works in the longer term, and does not need any subsequent redemption, is significantly reducing public spending with a corresponding reduction in taxation. The problem is that after many years of economic mismanagement it would take a relatively long period for confidence and investment to return to a previous level. In the meantime there may well be some stockpiling as a hedging function, because confidence is still weak.

      We do not in reality have any “Austerity” yet in the UK, so it is not possible to observe what the effects may be? Politicians however will always choose the option which buys them more votes, rather than what is best for any country. As a result, serious economic destruction is the only stimulus which causes politicians into being forced to take real corrective action; but if things have gone too far that can become too late.

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