Expect monetary volatility for years to come

By: Hans J Lysglimt

It is the big question, inflation or deflation? There are good arguments for both, and the crucial thing is that both are going on at the same time. Here at Farmann we are convinced that inflation will win in the end, politicians always go for the easy fix – press the button and print endless amounts of money – because they can, they will.
Yet, after having studies central banks more closely lately we are also convinced central banks will not give up their inflation targets without a fight. All major central banks monetary policy is now based on a low inflation target, either explicitly or implicitly. The interconnectiveness of global financial markets further reinforces this low inflation discipline.
So, as the new easy money sips out into the economy, and the banks start to lend again there will be upward pressure on inflation. Let’s talk about whether this is 6 months or 4 years away in another piece.
As inflation ticks up the central banks will at first allow it for some time, then implement actions to curb it. Since inflation has been low for some time they will at first allow a “temporary” overshoot of inflation. They will talk the talk. The might even implement some rather cosmetic actions as inflation overshoots. Our Norges Bank here in Norway has a two year time horizon on it’s 2.5% inflation target, so theoretically a couple of years of low inflation (as we have now) could be superseded by a couple of years of above target inflation.
As Norges Bank is allergic to deflation and would not allow prices to fall, not even below 1% – we can expect some symmetry to this deviation from the target, they might allow for a time 2.5% plus 1.5% deviation or 4% inflation. At first they can say this is temporary with some authority. In this scenario it is also likely that interest rates will rise accordingly, up by say 2.5% – putting pressure on all capital markets.
I use Norway as an example here, as all central banks closely follow each other and do adjust their policies to international movements.
The question then arises as the 4%+ inflation expands over time and it becomes apparent from futures markets that the markets expect inflation to stay.
That is when the tug of war between the central bank and the government will start.
I am convinced that central banks will at first curb inflation by raising interest rates and pulling in credit, hampering the growth that by then everyone is craving for (as you know we here at Farmann expect a depression, not just a recession). They can’t just give up on everything they have vested into their inflation targeting. As they restrict credit, and increase interest rates there will be major political cry against the central banks. “Central bank XX is hampering growth.”, “Give the people work.” etc will be the paroles.
Question then becomes what will come of the tug of war. Obviously the politicians will win in the end, and let loose the inflationary boom. But the most interesting and dangerous phase will be the preceding back and forth phase. It is obvious that this will become a major political question of the day, and that opposition parties will promise to reform the inflation targets and “bring interest rates down to more fair levels.” I therefore expect this tug of war might even go over an entire political cycle, the opposition party might need to take over, that is two to five years to be resolved and inflation finally to win out.
As you can see, this entire cycle might therefore last for some 10+ years before the inflationary wave is allowed to come ashore and wash away the debt burden.
For sure this transitional phase will be very volatile. Markets will rally on inflationary expectations (like we have seen March-June), crash down on central bank tightening only to rally again on political pressure for easing. This will not be done in once round, it will take several rounds – tug of war. We have just experienced a round of this volatility pattern in the March-June rally. Expect similar volatility patterns for years to come.

Tonight is midsummer eve here in Oslo, a truly special and magical night. The sky is an amazing light/dark blue through the night. Weather today is amazing with 27c in the shade, not a cloud on the sky, we will walk the ten minutes down to the shore tonight where there is a huge bonfire being lit. Friends, great seafood on the barbeque, go for a swim in the ocean, let the sun warm the skin at 11 PM. In the summer nothing beats being up here in the north.

Hans J Lysglimt
Oslo, Norway
June 23. 2009

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