Summary

In a globalized world experiencing multiple financial crises, the lag between money and inflation is extended. While central banks believe that they can pull back the excess money before inflation hits, it is unlikely in reality, as the pullback would trigger a great recession. They will likely tolerate all the money supplies out there to become inflation. The global economy may suffer a bout of severe inflation beginning in three years. As severe inflation usually triggers political turmoils, the future is more tumultuous than the past.

Inflation hedging must take into account of the price level. Many assets good for inflation hedging have high prices today. Also, high prices have increased supplies of such assets. They may decline despite rising general price level.

QE3 is coming

At last week's Jackson Hole gathering, Ben Bernanke defended his case for further monetary stimulus to help the economy. It appears that QE 3 is coming soon, possibly this month. I always believed that QE 3 would come this year. The reasoning was based how the Fed would react according to its dual mandate of price stability and employment maximization.

Short-term inflation data drive the Fed's inflation concerns. As a weakening global economy has recently driven down commodity prices such as oil, steel, etc., and the weak demand forces suppliers to discount, the current inflation picture looks benign. Even though these factors are short term in nature, the Fed has at least an excuse to ignore inflation risk. While there is usually an 18 month lag between monetary policy and its inflation consequence, most central banks tend to emphasize current rather than future inflation. The justification is that a central bank like the Fed is smart enough to take back the excess money supply before inflation hits, though there is little evidence that this is true.

Bernanke calls the US economy far from satisfactory. This is the right characterization. The current unemployment rate is 8.3%. This figure understates the dffficulties in the labor market. The current ratio of employment to population over 16 is 58.4% compared to 62.9% five years ago. The current total employment is 4.2 million less than five years ago. Considering that labor force normally grows by over 1 million per annum, there must be a lot of discouraged workers who have stopped looking for jobs and are not counted as unemployed anymore.

Monetary stimulus works through decreasing borrowing cost or devaluing currency. The former works if there are borrowers who respond to lowering interest rate. The US household sector suffers high indebtness. Its debt appetite is low. The US corporate sector is sitting on record cash level and isn't likely to borrow and invest just because the interest rate is a little lower. The US government suffers high fiscal deficit and couldn't increase it due to political deadlock. The dollar is strong due to the euro debt crisis and growth recession in the emerging economies. QE3 mY cheapen the dollar a bit but won't be enough to make a significant difference, because Europe is in recession and the growth rates in emerging economies are being halved.

QE3 will merely exaggerate bubbles that have emerged in some areas. The S&P 500 is close to all time high despite of a weak US and global economy. Internet stocks, for example, have valuation in stratosphere. Mahattan flats are surging in price again. If QE3 makes a difference, it is through making bubbles. While there may be some gain in the short term, it will lead to bigger problems down the road.

ECB will buy more bonds

Mario Draghi, the ECB President, promised to do whatever it takes to preserve euro. His statement turned around the sentiment in Italian and Spanish bond market. There is little doubt that the ECB has to support these markets to hold the euro zone together. And Draghi's commitment works only if it is open ended, i.e., it is willing to buy unlimited amount to cap the bond yields for Spain and Italy. The ECB purchases are likely to be trillions of euros. As the ECB purchases such bonds from investors, a portion of the money would be diverted out of the euro zone. The resulting euro weakness will be the immediate transmission mechanism for inflation to hit the euro zone. Of course, the net increase in global money supply will inflate goods and services that have low price elasticity. Food and oil are good examples.

The ECB bond purchases, if big enough, can hold the eurozone together. It works through inflation to lower the real cost of social welfare in the crisis countries like Italy and Spain. Cutting nominal expenditures has proven too hard to do. The main point is that the ECB intervention works only if it creates inflation. While the ECB mandate is price stability only, the Draghi promise has put holding the eurozone together ahead of price stability. This is probably the path for the eurozone in the coming years.

Japan may surprise

Japan remains in a vicious spiral of strong yen and deflation. The Japanese economy hasn't completely blown up because the government deficit is limiting the contraction of nominal GDP. The current government has passed a law to double consumption tax to 10% by 2015. This will lead to acceleration of nominal GDP contraction. The consequences for the banking system are severe, as contracting nominal income pushes some debtors into bankruptcy. Also, like in the eurozone today, the government revenue will contract due to the austerity measure. Its desired target of deficit reduction may not be met.

Deficit control and deflation are not viable combination. Japan has to end deflation for deficit reduction possible. The BoJ will be forced into drastic actions to end deflation. It requires either open eneded commitment to keeping yen low through intervention in the forex market or unlimited purchases of JGBs to target nominal GDP. The later would lead to yen devaluation, which forces other central banks to loosen monetary policy. The world as a whole will have more inflation.

China remains inflationary

Like in other economies China's inflation has slowed. The factors behind the trend, e,g,. overcapacity, high inventory, falling commodity prices, are all temporary. The fundamental factors like money supply and labor market remain inflationary. The PBoC reported that broad money rose by 13.9% in July, far above the potential economic growth rate.

The tight balance in China's labor market will drive the transmission from money to inflation. While the size of the cohort entering the labor market is slightly bigger than the one retiring, the portion available for manual labor is shrinking. The college enrollment has expanded dramatically to about one third of the age group from about 1% three decades ago. The college graduates are unwilling to join the blue collar labor force. It has resulted in blue collar wage higher than college graduate wage. This change is critical to the inflation tendency of the economy, as China's growth model is still dependent on manual labor.

While China is not embracing stimulus like in 2008, which is a good thing, the current spending pattern remains inflationary. Most money in the economy is spent by government agencies and state-owned enterprises. Neither pays attention to efficiency. When the temporary factors that hold inflation down are absorbed, the fundamental factors in labor market and expenditure efficiency will reassert and turn today's excess money supply into tomorrow's inflation