Mark Lister: Inflation and deflation dominate debate

U.S. Federal Reserve Chairman Ben Bernanke. Photo / AP

Opinion

France hosted the first meeting for 2011 of the G20 group of countries last week. Finance ministers and central bank heads from the world's largest economies gathered in Paris for the first time since the last summit in Seoul in November. That last meeting came just a few days after the US Federal Reserve announced its plans for another round of quantitative easing, dubbed "QE2".

This boils down to injecting US$600 billion ($800 billion) of funds into the US economy in an attempt to keep interest rates low, encourage consumers to spend, investors to move into riskier assets and to ultimately stimulate growth.

The Fed came in for criticism in Seoul that its policies were causing inflation and pushing down the US dollar. In Paris that theme continued and the Fed again faced questions from world leaders, particularly those from emerging nations, including China, regarding the effect that its loose monetary policy was having on global inflationary risks and asset prices.

Fed chairman Ben Bernanke was unapologetic, believing those nations should, among other things, allow their currencies to increase in value as a way to control such issues.

Listening to the world's largest nations continue to debate these issues is no real surprise. Many high-profile economists and commentators have also argued that the very low interest rates will cause inflation, while others regard deflation (prices and wages falling across the board) as a bigger threat. Those who see deflation as a significant risk point to high debt levels that may lead to falling demand, falling prices and anaemic economic growth.

Government and private sector debt levels are so high across Western economies that these risks cannot be ignored. In the US, total debt is close to 400 per cent of GDP.

In New Zealand, foreign debt represents 85 per cent of GDP and the ratio of household debt to disposable income has risen 2.5 times over the past 20 years, from 60 per cent in 1991 to 157 per cent today.

Economic growth could continue to be weak for some time as households, firms and governments defer consumption and use free cash to pay down debt. This process of "deleveraging" could take a long time and lead to low growth and deflation.

This inflation versus deflation debate has important implications for investors. Nobody knows which of these two scenarios will ultimately prevail; investors have no choice but to be diversified and protected to some degree against both.

Starting with deflation, longer-term bonds are the best protection because of their locked-in income. A five-year NZ government bond is currently yielding 5.5 per cent. If deflation occurred, this yield may fall, but an investor who bought in earlier would still receive their 5.5 per cent return.

With regard to inflation, "real" assets like shares and property are regarded as good hedges. The income they generate, dividends for shares and rental income for property, should rise over time. This growth in income means their underlying capital value should also rise.

We should note that this doesn't always hold. Shares struggled in the face of high inflation over the 1970s. But despite the risks, shares and property remain important inflation insurance.

Within shares, companies that pay a decent dividend, and that are in a relatively defensive sector like food retailing, utilities or healthcare, can also provide a degree of deflation protection. Cash and short-term deposits are also an important inflation hedge. If inflation rises, so too should interest rates, and cash can be quickly put to use to take advantage of these higher rates.

For the record, inflation risks concern us most in the medium term. However, a prudent investor looking to guard against both outcomes would likely hold some cash for inflation protection, a laddered portfolio of bonds of varying maturity dates as deflation protection, a little gold for "crisis insurance" and a portfolio of property and shares for inflation protection.

One person who is concerned about inflation and has been highly critical of the Federal Reserve's actions is Thomas Hoenig. What's remarkable about Hoenig is that he is not some conspiracy theorist who writes a blog about gold. He is, in fact, president of the Federal Reserve Bank of Kansas City.

Hoenig attended and voted at all eight Fed meetings held over 2010. And at every meeting he voted against the current policy of extremely low interest rates and quantitative easing. He was a lone voice: 10 votes in favour, one against, every time. Probably to the relief of the other committee members, Hoenig's time on the Federal Open Market Committee is up. Normality has returned - the January vote was a unanimous decision.

In his view, by keeping interest rates at close to zero, the Fed is "asking savers to continue to subsidise borrowers". He believes the recent run up in oil prices and the stock market has been caused by excessively low interest rates.

He is also concerned that over recent decades people have come to rely on monetary policy as the solution to any problem. Any crisis, be it a financial meltdown, the economic aftermath of a terrorist attack or the costs of a war, can all be rectified by cutting interest rates. He believes this is unrealistic and dangerous, and causes bubbles.

He believes inflation will build slowly, as it did in the 1960s and 1970s, and he regards inflation as utterly unfair. He describes it as a regressive tax, eroding the buying power of the poor and people on fixed incomes while "those who have money and are savvy come out ahead".

He is angry the giant financial firms on Wall St were not broken up and pointedly blames crony capitalism for this failing to happen.

If he made policy he would focus the US on high savings rates, low leverage and a strong currency. He also believes the US can become a low-cost manufacturing producer again: "Germany has done it, and we can too."

While all of his thinking may sound old-fashioned to some, he makes many valid points that are equally applicable to New Zealand. Savings rates have to rise, leverage has to fall and the only path to higher living standards is competitiveness and higher productivity - definitely not financial engineering.

Savers cannot subsidise speculators any longer.

Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.