TCS Daily


The Dollar, the British Pound, and Inflation

By John E. Tamny - April 27, 2007 12:00 AM

The British pound rose above $2 this week, its highest level since 1981. Despite the pound's strength, the U.K.'s Retail Price Index (RPI) jumped to 4.8 percent, and its Consumer Price Index (CPI) reached a 10-year high of 3.1 percent; a seemingly odd development considering lower levels of government measured inflation in the weak-dollar United States. Arguably the answer to this anomaly lies in the sticky nature of dollar-priced goods, certain ways in which inflation is measured in both countries, along with the certainty that there's a great deal of hidden information when measuring currencies in relative terms.

Regarding inflation in the U.S. and U.K., questions have logically come up about why pricing pressures are higher in the latter. With inflation a monetary phenomenon, and with the pound stronger than the dollar, inflation would by definition be rising at a faster rate in the U.S. That it's presently not first of all speaks to the flawed process by which the U.S. and U.K. measure inflation. Simply put, the CPI in both countries is merely a basket of goods chosen by economists where they guess what goods people typically buy. There is no substitution accounted for here; as in if rising apple prices caused consumers to switch to oranges, the CPI would not measure the change in how we shop.

One factor noted in the rise of the British CPI was more expensive computer games. The problem there is that the calculation doesn't nor can it tell us if the rise was actually currency related (inflation), or due to more popular games driving demand above supply (a non-inflation factor), or a result of more elaborate games that would logically command higher prices. Milk prices rose 2% compared to one year ago when they fell 8%, but the calculation could not account for why prices changed along with any substitutions a rise in milk prices might have engendered.

What's also left out is that while prices everywhere are sticky, they are stickiest in the United States. According to Stanford economist Ronald McKinnon, changes in the dollar's value lag the most in terms of altering the value of consumer goods. When the dollar rises or falls in value, it takes a lot longer for changes in the dollar unit to impact goods priced in dollars.

Returning to the U.K., some of the ways in which they calculate inflation help to explain the recent jump. For one, while mortgage interest payments are in no way a retail price, increases in those payments flow through as "inflation" in the British calculation of its RPI index. Since last summer, the Bank of England has hiked its short rate on money 75 basis points; meaning its efforts to curb inflation with rate hikes have actually increased its rate of inflation. That there's talk of further hikes of 50 basis points means inflation as measured by the RPI will continue to go up.

Britain's Value Added Tax (VAT) also factors into supposed pricing pressures, in that rises in the VAT are calculated as inflation even though the price rises are due to government taxation. Importantly, the VAT hasn't been hiked since 1991 when it rose to 17.5 percent. At first glance, this would suggest that it was not a factor in recent CPI and RPI calculations. On the other hand, a report on the British website Politics.co.uk noted that while the VAT itself has remained stable, "the range of items subject to VAT have risen year on year." Depending on changes in the British basket, some of the alleged inflation could simply be a result of the VAT's widening range.

With the pound presently buying two dollars, some say it's in "nosebleed" territory, with a drop in its value a near certainty. What's lost in this is that the pound hasn't really been so strong as the dollar has been very weak. According to the economists at Western Asset Management, the dollar is more undervalued relative to the pound than at any time in the last 30+ years.

That this is true also helps to explain why government measures of British inflation are presently so high. As Alan Greenspan used to regularly point out, "inflation strikes with a lag." From April of 2005 to April of 2006, the price of gold in pounds rose 55 percent; meaning the pound experienced a bout of weakness as recently as a year ago. Prices once again being sticky, some of the U.K. inflation today is simply a result of this past weakness finally filtering into consumer prices. Conversely, over the last twelve months, the pound has stabilized against gold, while the dollar has fallen another 11 percent. The problem with measuring currencies against each other is that there's no way of telling if one currency's weakness is due to the other's strength, or if one currency's seeming strength is the illusory result of the compared-to currency's weakness.

When it comes to the British pound vis-à-vis the dollar, it seems that the latter phenomenon is at work. Using gold as an objective measure, all major currencies have been weaker over the past few years. Broad currency weakness as measured in gold likely points to higher inflation around the world, and while it's been slow to reach dollar-based countries, history suggests the U.S. won't be immune to the inflation that's already reached the U.K.

John Tamny is the editor of RealClearMarkets. He can be reached at jtamny@realclearmarkets.com


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12 Comments

Three types of inflation...
Let's ignore the variables of measurement and talk about the underlying value of money. Note that there does not seem to be a direct relationship between domestic inflation rates and foreign exchange rates. But first, inflation itself.

Let's discuss three distinct types of inflation. Classic inflation. Keynesian inflation. And Mature economy inflation.

In classic inflation there is too much money chasing too few goods. This occurs when all of the goods in the market are essential (unfulfilled consumer demand) and the market (supply) will clear. Add to this a government that is "printing money" to pay its bills and we have classic inflation. The value of currency simply collapses. People need a wheelbarrow to carry enough cash to buy a loaf of bread.

Under Keynesian inflation in a developing economy with brisk growth the actual values of productive resources in the economy are adjusting upward. Growing companies have high margin opportunities that support high interest rates on incremental (borrowed) working capital. Expanding companies bid up the cost of scarce labor resources. Residential spaces (either rentals or homes for sale) become more expensive as workers move into the market. The value of raw development land runs up. Consumers have more money to spend on essentials and the businesses who serve them raise prices to cover their own increased costs and to take the opportunity to generate higher margins for themselves.

Inflation makes paying back loans with cheaper future dollars attractive. High interest rates incorporate the anticipation of future inflation into net present value calculations. When inflation does slow down (and interest rates drop) the banks stand to benefit from such high interest loans in their portfolios.

Keynesian inflation and rapid economic growth work together to adjust the relative currency value of the nation's growing wealth. In this case, moderate inflation is healthy.

Finally. When the economy matures and GDP expansion slows down such upward adjustments are no longer supported by underlying rapid industrial growth. Keynesian inflation is disabled. Moderate inflation that was once beneficial turns ugly.

Excessive inflation is actually now caused by the market's anticipation of future inflation. The market itself creates artificial inflation by hedging. Interest rates are high to account for the declining value of money in net present value calculations. Real estate speculation (even with high interest rate leverage) replaces investments in industrial development. This is because projected slower market expansion can no longer support any such increases in capacity. The incremental Cost of Capital puts many projects below the line.

Prices are up but unit sales are not growing. Companies milk their factories rather than building more.

But the real estate play looks great. Market values justify more lending and higher interest rates. Even risky loans find an eager secondary market.

Hedging in such commodities as gold lead to broad speculation in commodities as money moves away from equities. This phenomenon leads to further artificial inflation.

Reduced investments in capital goods slow industrial activity generally and consumer spending does not make up the difference. Prices continue to climb while people are being laid off. Stagflation.

This leads to a collapse of inflated asset values across the entire economy. Mature balance sheets suffer. In the US after 1980 we simply stopped making real estate loans as mortgage rates kissed 18%. In Japan after 1990 the yen sunk into deflation. In the rest of Asia, after 1997, the real estate bubble fueled by money racing out of Hong Kong burst as that island finally went back to China.

Actual inflation (forget how we measure it) in a mature economy must run low enough that interest rates do not include a significant adjustment for net present values. Otherwise, high interest rates can cripple the rapidly growing, small companies who need working capital leverage. Such small companies drive GDP expansion in a mature economy that would otherwise not support any inflation at all.

Inflation cannot run so close to zero that we risk deflation. The Fed likes its 1.5%-2.0% range as a target. However, 3% is historically more normal, probably healthy and sustainable.

The value of money...
Intuitively, a weakened currency should lose buying power. Similarly, a strengthening currency should increase in value.

By this logic any currency that is weaker in the foreign exchange market should undergo domestic inflation. It follows that a currency strengthening overseas should experience low inflation back home. Maybe even deflation. As did happen to Japan following the Plaza Accord (1985).

Nevertheless, the dollar is weaker against the euro but the US has a low rate of domestic inflation. This probably means the dollar is about flat and the euro is relatively stronger than it was. That seems reasonable as the EU has finally achieved economic traction while we simply recovered from our recession.

Alternatively, the Philippine peso has strengthened about 15% against the dollar since October 2005. How then can we explain their 8%-9% inflation rate?

The peso must be strengthening if the dollar is, indeed, flat. Therefore, the Philippine economy must be expanding if the peso is stronger and this is combined with stimulating Keynesian inflation. Indeed, we already know that the economy of the Philippines is moving forward now. And it is poised to take off.

Now comes the British pound. Part of the strength of the pound is related to the strength of the euro against the dollar. A close relationship exists between the British economy and that of the EU.

Part of the pound's somewhat higher (than the dollar's) measured inflation rate is certainly anomalous, as the author describes. Indeed, it may be that US inflation and that in the UK are similar. And that both are in about the right place.

If that is the case then we should not expect to see a fundamental correction with the pound. And we should not expect any underlying global inflation to come looking for us.

"Using gold as an objective measure, all major currencies have been weaker over the past few years. Broad currency weakness as measured in gold likely points to higher inflation around the world..."

Gold might not be much of an objective measure. There are no underlying (production) fundamentals supporting the current market price for this commodity (that is really just refined dirt).

The market for gold is dominated by traders and speculators. The legitimate hedge play in gold might have started its rise in 2002. But that business is long since past. Now it simply trades against its own 90 day rolling average.

Further, there is no such thing as global inflation because inflation means different things in different parts of the world. There are three distinct types of inflation out there. Each of these has a different etiology and a completely different economic impact.




Keynsian?
So it seems you like Keynsianism, whereby the government prints money to pump the economy; this corresponds with your ideas of very strong governments. This meanst that you're an advocate of the dangerous fallacy that printing money generates growth and prosperity. This explains a lot of your wacky comments. Also the talk of 'speculators', actually guys who are sending valuable signals about what's going on, by putting their money where their mouth is. Whenever you hear guys complaining about speculators, you know for sure that you have guys that don't like free markets, as Keynes didn't, as commies didn't, as fascists didn't. Even your talk decrediting gold shows this, especially since if there were a true hard gold standard there would be no inflation at all. That's why command economy governments don't like it, and that's why they created central banks.

I do like it all...
Classic inflation, Keynesian inflation and inflation in the Post Industrial Society. All three.

Keynesian inflation operates to stimulate a rapidly growing economy where undervalued productive resources need to be priced upward as its wealth-creating operations becomes more competitive in the global arena.

This inflation is accompanied by a strengthening of the nation's currency. This seems counter-intuitive. The currency strengthens against foreign exchange yet weakens at home as the economy strengthens and asset
values adjust upward.

We like to think that the currency is weakening under Keynesian inflation. But actually the resources being repriced are strengthening while the currency itself should be getting stronger.

Once such an economy joins the club and its growth slows down any further substantial inflation consumes the value of balance sheet assets (if they do not have market values) denominated in that currency, low yielding, fixed interest debt instruments and fixed incomes.

And the higher interest rates required for "cost of capital" net present value calculations cripple successful small companies as they seek to leverage their operations with borrowed capital. This inhibits the growth of an already slowly growing mature economy. Risking a drop into recession.

In a mature economy robust inflation rates lead to stagflation rather than to the Keynesian stimulation we see with rapidly developing economies.

As an example, you need extra calories while you are exercising hard and growing fast when you are an adolescent. Once you mature, however, those same meals will only make you fat and this threatens your health.

Furthermore, inflation hedging leads to speculation in such fundamental, underlying repositories of value as real estate. This leads to an asset price bubble that must correct downward. Often dramatically.

The commonly held idea that there is only one type of inflation in the global economy is fundamentally flawed.

liking it all
There are no 'undervalued productive resources" in a free economy. But people who like command economies, like yourself, will use such comments because most people don't understand them, to make your case for more government distortion of the economy. But I do like your last sentence though. The only type of inflation is that causes by the interference of the government in the economy. So let's recapitual what you like: 'the dangerous fallacy that printing money leads to growth, command economies by beurocrats, the idea that government functionaries can correctly price everything in a economy, the fallacy that beaurocrats should allocate resources, the the govenmet should determine what people want to spend their own money on. Jeez, maybe you really are an adovocate of the wacko 'Social Credit' movement.

Re: liking it all
"There are no 'undervalued productive resources" in a free economy."

That'll be news to Warren Buffet...

What in the world is a "free economy"...
Example: If I have a factory space in Cavite that I purchased eighteen months ago for $100,000 then this was equal to 5.5 million pesos at that time.

An equivalent space would be worth, let's say $750,000 in an industrial park in the United States. This value is based on the income I should be able to generate with such a property. As its rental value or housing my own operation.

Because the Philippine economy is heating up the value of this "productive resource" in the Philippines needs to appreciate faster than its counterpart in the US. So that in 20-30 years they might have a roughly similar value, all else being equal.

Philippine inflation is running about 8%. So the 5.5 million pesos have increased by a factor of 1.12 (in 18 months) to 6.16 million pesos. However, the peso itself has strengthened from 55 to 47 to the dollar during this same period. Therefore, the property is now worth $131,000. And this increased value is sustainable as we export more high margin goods. We get a double bump up from Keynesian inflation and a strengthening of the peso.

During this same period the US property value would have gone up to maybe $775,000. due to our own mild rate of inflation. It will take the developing countries a while to catch up because the larger base price increases significantly in total dollars even with a small inflation multiplier.

If the peso was flat the $131,000 property would only be valued at $112,000 due to Keynesian inflation. Without inflation the value would be $117,000 if the increase in value was only due to the stronger peso. Like I said. Double bump when the economy is on the run.

Let's recap: Printing money leads to classic inflation that destroys the value of currency and takes the economy down with it. Keynesian inflation is healthy for a developing economy. Inflation in a Post Industrial, mature economy is particularly dangerous.

We have said absolutely nothing at all (up to now) about government imposed price controls or rationing. Where did that come from?

Your theory of Social Credits is from early in the last century and it constitutes a simple math deception. Like a magic trick. It is fun for the children.

Goes like this. Cost of Goods Sold is made up of Material, Labor and Overhead. However, only the money for material and labor goes to consumers. Therefore, the money consumers have to spend can only cover that portion of the total costs. How can the price (across the entire system) cover the additional cost of overhead (capital machines and real estate, etc.)? The extra money must come from somewhere? Where? All the answers imply something very bad.

It is a parlor trick. Of course, the money for the actual overhead was already spent long ago (and the system already has it). The overhead cost is actually an accounting, non-cash, charge called depreciation.

The Social Credits people did not understand Balance Sheets, Income Statements or finance. Capitalism gets a bad name when the socialist cranks start thinking too hard.

Where do you dig this stuff up?

re: W. Buffet and liking it
Yes, guys like him and me do for undervalued companies, and if it's a free market, guys like us, investors, not speculators, recogize it. But my point was that this can not be done in countries that have governments that distort the economy in various ways, eg inflation, wage/price controls, hiring quotas. So in a free economy, all that is taken care of, so nothing stays undervalued or overvalued.
RE Forest; I know i'm not a native speaker so maybe don't recognize the way you talk. But it doesn't ring true to me, as if your quoting from some follets or whatever. Your weird economic theories don't correspond to any mainstream notions. BTW, if all that activity in the phil, i thought you were against that? Are you one of those foreigners who wants to keep them exploited as you said before? As for me I feel pround that I've contributed so much over the years to the phil economy. In fact, I'll probably be back in Baligabo again in a few weeks, to visit one of my kabits.

Who is you quorte from?
THis one, "Using gold as an objective measure, all major currencies have been weaker over the past few years. Broad currency weakness as measured in gold likely points to higher inflation around the world..."

It's weaker because governments can't manipulate it. They hate it, keynsians hate it, they love fiat money. It's in their interests to cause inflation. Where's the quote from? And gold is not just refined dirt, it's acutally a 'noble' element, or metal. Aluminum and steel are refined metals too, but all thru history , almost every culuture has valued gold more. It's a great backing for currencies.

Quote...
The quote is from the article. Near the bottom.

yes re gold
Yes, found it again, and my comment still stands, and is accurate. And even though governments try desperately to decuple their fiat currancies from gold, it still is used. So before gold was $35, 44, etc. now over $600, or whatever. As governments debase, in order to manipulate, it takes more of their fiat money to buy the same amount of gold. Gold holds value, the currencies go up and down in comparison to it. But if there were a true gold standard for currencies, then there would be no problem; whoops, except for politicians.

The value of gold...
Gold is a commodity that mostly sits around in a lump. It does not produce income itself and the money tied up in gold could either be invested in bonds or it could be working capital. Why do you think corporations do not show a Gold line item on the balance sheet? Because it is a lousy asset. Gold is an ego purchase. No good as an investment.

The price of gold sat about flat below $300 for years. We went into recession, here in America, and gold made a move. With cheap money people seemed concerned about the possibility of inflation. So the hedge play started gold moving up.

Gold trades against its 90 day rolling average. Period. There are no supply and demand fundamentals involved and there is no particular relationship between gold and any currency. Any hedge pay constitutes a one time event. After that it is pure trading.

Gold will eventually drift back down below $400 as the players lose interest and go do something else. When there is another inflation scare it will move up again, just like it did this time. But it doesn't mean anything fundamental.

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