Money Matters: China's Property Market and the Key to Global Deflation.

Independent Insight Provider

Stewart Paterson

Taurus Advisors LLP

Thematic (Sector/Industry)

Austria Financials / Thematic (Sector/Industry)

Advocates of inflation targeting claim that central banks can control prices through monetary policy and that by targeting a relatively low and stable rate of inflation (usually around 2%) policy makers can achieve both price stability and full employment - or at least minimize the loss of output relative to potential.Recent experience suggests that the claim that central banks are able to control the overall level of price changes in the economy is, at best, not always true. In fact, it may never have been true to any degree of useful exactitude.There is likely to be an asymmetry in the ability of central banks to influence the direction of inflation. Given the current structure of the global economy it appears easier to bring inflation down than to push it up but that can change: it has done in the past and may be doing so again.It is true that experience suggests that, if the central bank sets interest rates high enough demand will be subdued and prices will probably fall but that is not the same thing as exercising control over the level of prices. The failure of monetary policy in the recent past to drive inflation towards target in a reasonable time frame is notable. The methods used to engender inflation and their legacy also call into question whether central banks will be able to cap the rise of inflation going forward in a way that fulfills the full employment part of a dual mandate for those that have one. The ECB has failed both to minimize the amount of lost output (unemployment) AND to engender the targeted amount of inflation - a short-coming that may well have been unavoidable but that calls into question the existence of the Eurozone. The implications of this failure for the costs of capital are potentially very severe. As I write German 10 year bonds yield 0.43% while Swiss ones yield.-0.05%. Us and Japanese 10 year yields are 2.6% and 0.07%% respectively. Bond prices (directly) and other financial and real asset prices (indirectly) have risen as a consequence of central bank attempts to reach targeted levels of inflation. Their failure to achieve their goal promptly has augmented and elongated the price rise.Now investors find themselves locked into very low nominal returns just as inflation appears to be returning (at least for now). The realization that policy makers may not be able to control inflation to the upside in the same way that they could not control it on the downside and that the rate of inflation over the next ten years is unknown to anybody and everybody (including the central bankers) should lead to a complete re-ricing of the bond market.Many corporates in Asia have borrowed heavily. Some business models are dependent on leveraging very mediocre underlying returns on assets. As nominal costs of capital rise to reflect the uncertainty around future inflation a de-rating of financial assets is likely to ensue.

Advocates of inflation targeting claim that central banks can control prices through monetary policy and that by targeting a relatively low and stable rate of inflation (usually around 2%) policy makers can achieve both price stability and full employment - or at least minimize the loss of output relative to potential.Recent experience suggests that the claim that central banks are able to control the overall level of price changes in the economy is, at best, not always true. In fact, it may never have been true to any degree of useful exactitude.There is likely to be an asymmetry in the ability of central banks to influence the direction of inflation. Given the current structure of the global economy it appears easier to bring inflation down than to push it up but that can change: it has done in the past and may be doing so again.It is true that experience suggests that, if the central bank sets interest rates high enough demand will be subdued and prices will probably fall but that is not the same thing as exercising control over the level of prices. The failure of monetary policy in the recent past to drive inflation towards target in a reasonable time frame is notable. The methods used to engender inflation and their legacy also call into question whether central banks will be able to cap the rise of inflation going forward in a way that fulfills the full employment part of a dual mandate for those that have one. The ECB has failed both to minimize the amount of lost output (unemployment) AND to engender the targeted amount of inflation - a short-coming that may well have been unavoidable but that calls into question the existence of the Eurozone. The implications of this failure for the costs of capital are potentially very severe. As I write German 10 year bonds yield 0.43% while Swiss ones yield.-0.05%. Us and Japanese 10 year yields are 2.6% and 0.07%% respectively. Bond prices (directly) and other financial and real asset prices (indirectly) have risen as a consequence of central bank attempts to reach targeted levels of inflation. Their failure to achieve their goal promptly has augmented and elongated the price rise.Now investors find themselves locked into very low nominal returns just as inflation appears to be returning (at least for now). The realization that policy makers may not be able to control inflation to the upside in the same way that they could not control it on the downside and that the rate of inflation over the next ten years is unknown to anybody and everybody (including the central bankers) should lead to a complete re-ricing of the bond market.Many corporates in Asia have borrowed heavily. Some business models are dependent on leveraging very mediocre underlying returns on assets. As nominal costs of capital rise to reflect the uncertainty around future inflation a de-rating of financial assets is likely to ensue. 

Sumitomo Mitsui Financial Group (8316 JP)

Mitsubishi UFJ Financial (MUFG) (8306 JP)

Sumitomo Mitsui Financial Group (Sponsored Adr) (SMFG US)

Sumitomo Mitsui Financial Group (Sponsored Adr)

Shanghai Pudong Development Bank Co. (600000 CH)

Mitsubishi UFJ Financial (MUFG) ADR (MUFG US)

Money Matters: The Failure of Inflation Targeting and the Implications for the Cost of Capital.