Monday, June 27, 2011

PIMCO's Worah Warns on Inflation

Mihir P. Worah of PIMCO, the world's largest bond manager, writes in his most recent Economic Outlook that:

Given the global supply/demand imbalances that we see, we expect commodity prices to be generally rising going forward, noting, of course, that commodity prices are volatile and that there will be differentiation among commodities. Much of this is related to the dynamics in and between developed and emerging economies...Rising commodity prices along with reflationary policies from many developed market central banks should result in modestly higher inflation going forward.....

Currencies may become another strong driver of inflation, especially among developed economies. We anticipate policymakers in the developed world will attempt to make their economies more competitive via a cheaper currency, which likely will, for net importers like the U.S., lead to higher inflation.

Also, as emerging economies face their own inflationary pressures they may find that they cannot continue to couple their currencies to the U.S. dollar and to combat inflation they need to let their currencies appreciate. This is another channel by which emerging markets may export inflation to developed nations that buy their goods... is our view that recent increases in commodity prices are not transitory. They may not increase at the rapid pace seen recently, but they should continue to increase at a pace faster than, on average, the Federal Reserve’s 2% target for inflation.

If, as we expect, headline inflation continues to outpace core inflation, or if the gap widens, there is a risk central bankers could lose credibility over time, causing an unanchoring of inflation expectations. That could raise the risk of monetary policy error; the Fed persistently looks through and allows steady erosion in consumers’ purchasing power.
Worah is correct in his points above, but he goes on to say that he doesn't expect the price inflation to be as bad as it was in the 1970's. It is difficult to understand his thinking here. Given the debt problems around the world. This is likely to lead accelerating money printing by the Federal Reserve and other central banks. His weak argument for mild price inflation goes this way:

 That said, we are not predicting an inflationary spiral resembling the 1970s, for several reasons. People arguably had less faith in the central bank back then and so inflation expectations became unanchored easily. Also, unions generally had more clout in that era and could demand higher wages to match inflation expectations. The situation is different today.

If anything people are much more suspicious of the Federal Reserve. Once price inflation hits double digit rates, price inflation expectations will skyrocket. Further, his throwing unions into the picture is way off. He's talking about some kind of Keynesian cost push inflation. As Milton Friedman said, inflation is always a monetary phenomena. And the Fed and other central banks will be under heavy pressure to print money to bailout governments that are on the brink of default.

That said, there is plenty on new money in the system that will continue to result in higher prices, now. The money printing down the road will just make matters worse. Most likely at double-digit rates.

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