Macro Review: A Risky Approach

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Government policies to expand and loosen the money supply have increased the chances of future inflation. For the short-term, these policies help limit deflationary risk, but the key to recovery is improving consumer demand.




At the G-20 Summit in London, world leaders agreed to inject 5 trillion dollars – or 9 percent of 2008’s global GDP – of stimulus spending by the end of 2010. These measures are expected to increase output by four percent.



Behind this massive influx of government money is the knowledge that deflation is one of the most pressing current threats, as economies around the world contract. Deflation would mean that the same amount of money could be traded for more goods in the future, causing the nominal value of assets to shrink. If this happened, banks concerned about growing default risk would demand more collateral before agreeing to lend, and companies and households would postpone spending and stockpile their money instead. This would further dampen demand, forcing more factories to shut down and lay off workers.

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Increasing the money supply, and consequently increasing the chance of inflation, is one way to offset these dangers. Current policies have used this effectively, although the cure is somewhat artificial. The most remarkable example is the Federal Reserve’s direct purchase of U.S. Treasury bonds, which has nearly the same effect as printing money and has bred reasonable anxiety about future inflation.



For its part, China’s loose monetary and credit policies have also boosted expectations of inflation. Chinese banks are far more willing to lend than their Western counterparts since the economy is still largely driven by government projects and state-owned enterprises. China’s new loans are likely to exceed 4 trillion yuan in the first quarter, only a hair shy of the total sum of loans made in 2008.



Other policies have signaled a high chance of inflation in the future. The government has set its inflation goal at 4 percent, higher than the market perception of price trends. This hints there might be tolerance for higher prices. Adjustments to key commodity prices are another sign. Last week, the government raised retail prices for gasoline and diesel. In light of this, sales of cars and apartments grew in March, pushing investors back to the stock market and producing an impressive rally.



In the ideal scenario, anticipation of future inflation encouraged companies to stock up on materials before prices rise. This increases demand in upstream industries. Likewise, consumers opt to spend sooner rather than later to make most of their money. Finally and more importantly, increased prices and demand boosts company profits and enables them to improve capacity.

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But raising the chance of future inflation is not a panacea. To begin with, when inflation usually sets in lags behind expectations. Past experience suggest that M1 – all the money in circulation plus checkable demand deposits – can serve as a leading indicator of CPI and PPI, in advance of six months or longer. Assuming that the M1 already made it over the trough in the first quarter, CPI will probably hit the bottom in the third quarter, and PPI even later. This is to say, chances are that by the end of this year, CPI will be only slightly higher than over a year ago, and PPI will see negative growth.



Another issue is that while some companies have begun to build up inventory again to take advantage of sliding prices, they have learned a lesson from the painful de-stocking process that started last year and are unlikely to resume the previous pattern of rush buying.



Moreover, the government stimulus plan and the credit boom are structurally skewed towards investments in upstream industries such as mining, petro, mineral, chemical and machinery. Uneven growth between upstream and downstream industries has been observable since 2007. As manufacturers and other downstream industries are buffeted by dwindling exports and puny domestic demand, the expansion of upstream industries can only end with over-capacity. This would further drag down PPI, discouraging any more “re-stocking.”



The consumer side is just as problematic. While some consumers might increase their spending in expectation of inflation, others might choose to save more to counter the deterioration of purchasing power. Considering how underdeveloped consumer credit is in China – the credit boom went almost entirely to businesses rather than households – a widening gap between supply and demand and suppressed prices is evermore likely.

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With these problems unresolved, the possibility of economic statistics going south again before they truly rebound cannot be ruled out. Evidence of this is found in electricity consumption. Year-on-year growth had jumped to over 1 percent in the first half of March, only to fall to negative 2 percent in the second half of the month. This suggests a resumption of production capacity before generators were idled again due to weak demand.



Playing with inflation pressure is like playing fire – once inflation is unleashed, the cost to rein it in can be painfully high. The worst outcome would be “stagflation,” in which inflation is accompanied by weakening demand.



Instead of stirring up this nest, a more sensible means to deal with the risk of deflation is to beef up consumer demand. This is the key step in China’s structural transition. The economic downturn has opened up a better window for this adjustment than there was when things were booming, since stimulating consumption not only helps boost growth but is also inflationary.