Who’s to blame for global inflation?

Inflation, a global concern, is almost everywhere considered to be a monetary phenomenon. In reality, money is not what really drives inflation.

“It’s fiscal pressure and bankrupt governments,” said Dylan Grice, global strategy research analyst with Société Générale. He was speaking at the CFA Institute’s annual conference in Edinburgh, Scotland, earlier this year.

Most of the past episodes of inflation suggest two very common characteristics. Grice identifies them as stressed public finances and politicized central banks.

“You find these two elements in every single episode of hyperinflation,” he said in reference to the coming Japanese hyperinflation, which he said was now the only way Japan, and very soon the U.S., can come out of recession.

Hyperinflation is not just an economic malfunction, it is a societal malfunction, he said. “Everything breaks down; so normally when you see hyperinflation, you see wars, revolutions and [other] extreme acts that go beyond day to day economic activity.

For most of the last year and a half there has been a growing focus on inflation; first in the developed world, and more recently, in emerging markets.

“What’s interesting about the world right now is if you look at most measures of inflation in developed countries—stripping out energy—2010 was the lowest yield on record since 1970 for inflation in the developed world,” said Russ Koesterich, head of active strategies, Barclays Global Investors. “In spite of that we have a year where gold was up by 30%, silver 80%.”

Koesterich observed that investors in advanced economies appear to be obsessed with inflation hedging despite the absence of inflation anywhere in developed markets.

So what’s making investors so nervous? No matter where you begin, it all seems to point to unconventional monetary policy and the resultant fear of its long term impact. But there’s something else at play: inflation volatility.

“Inflation volatility in the OECD countries is now it’s highest; if you look at the U.S., volatility in inflation in the last 10 years is the highest since 1957,” said Koesterich. This is unusual by the standards of the last 20 years when inflation was fairly low and stable.

“One of the reasons market multiples arguably not higher than they’d otherwise be is that investors no longer trust inflation rates will remain stable.” Hence, widespread investor aversion to inflation.

The situation in emerging markets is very different, in that there’s some real evidence of inflation. In India inflation is running at about 9%, Brazil 6% and China over 5%. “If I look at the inflation situation in emerging markets, some of it is like the old-fashioned variety: too much credit growth,” said Koesterich.

Bank lending in China was growing at 30% in 2010; consumer credit in Brazil has been growing far too rapidly; and a similar situation faces India. Koesterich says this is the kind of inflation that central banks can generally deal with.

But there’s another important aspect of inflation in emerging markets: much of the inflation is being “imported” from the developed world.

The challenge for many in the emerging world is that none of this inflation is the old-fashioned variety that comes from credit growth and economic overheating; it’s coming from the inflation generated by the unconventional monetary policies adopted in developed economies.

“It’s actually manufactured in London, Washington D.C. and other developed countries,” he added. “That was one reason there was such a strong reaction from some emerging markets to policies in Washington.

“Arguably the decline of the dollar and expansion of the Fed balance sheet have contributed to commodity inflation,” said Koesterich. “In developed countries you can live with that; but if you look at China, food alone is 35% of what people spend their money on. In India it’s 45% and in Indonesia it’s close to 50%.”

On the assumption that the U.S. will not embark on a third round of quantitative easing, inflation in emerging markets should start to come down, but “different countries will be at different stages of inflation cycle.”

Globally, Koesterich expects low inflation, except for energy and food, in developed markets and modest to high inflation in emerging economies. However, it’s the future path of inflation in developed economies that’s causing much debate and disagreement.

“There’s a number of people who think inflation is a real threat, which is not unreasonable given the deleveraging that’s happening in [advanced] economies,” said Koesterich. “Then there are even more people who believe that over the next two to three years we’ll see significant pick up of inflation.”

Looking at the monetary picture, he said, provides some insight into which of the two arguments is right. “This is important because most people know that in the developed world there’s a lot of slack in those economies.”

In the U.S., high unemployment has meant no growth in wages in the past three years. In most of the developed world—Europe, Canada, the U.S., Australia—central banks have pursued very unconventional monetary policies over the last three years.

Koesterich believes there’s significant scope for policy mistakes over the next few years.

“The mechanism that gets money from central banks into the real economy has been broken for the last three years,” he said. “What’s happened over the last few years [in the developed world], is that the banks have not been lending, and because of this the money supply has been growing very slowly.”

In the short-term, the growth in the money supply and inflation don’t show any correlation, but about two years out that relationship becomes important. “I do worry about the long-term effects of the Fed’s program [and policies of the ECB]; but until 2013, there will be little in the way of inflation.”

Another thing to keep an eye on is rising inflation expectations, one of the rationales given for QE2. “The Fed was very aware of this and [Fed chairman Ben] Bernanke was sensitive to this risk.”

There are yet more things to worry about. One of them, Koesterich said, is how the central banks throughout the globe will draw their monetary policy. Second, many consumers are becoming more and more sceptical of the “willingness of the Fed and other large central banks to actually address inflation. And this concern is reasonable given the fiscal situation in many countries.”

Inflationary pressures are a reality that much of the world is coming to terms with. While emerging world has been aggressive in taming inflation, the developed world, at least for now, seems to favour the go-slow approach given the softening in employment data, in the U.S. and Canada, European debt crisis and the ongoing geopolitical events causing uncertainty in global financial markets.