The Inflation Tipping Point

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THE INFLATION TIPPING POINT: Ever since the global financial crisis struck in 2008, there has been a lively debate between those who have been expecting a prolonged deflation and those who have been predicting a rapid transition to inflation. In certain respects, both sides of this debate have been correct in their arguments, if not entirely consistent. Recent data indicate, however, that the terms of debate are now shifting decisively in favour of those anticipating inflation. Within a period of months, financial markets will begin to adjust accordingly, indicating that an important inflation “tipping point” has been reached. Once this occurs, there is a risk that economic behaviour changes in ways that can damage economies. Investors need to prepare accordingly.

THE INFLATION TIPPING POINT

The concept of a “tipping point” can apply to a wide range of phenomena. One classic example is that of a crowded theatre slowly filling with smoke. At first, perhaps only one person notices the smoke and, comforted by the fact that others remain calm, remains seated, if slightly on edge. But then a handful of others also notice and become concerned. Finally, at some point, these folks stop watching the show and instead start watching each other. As the growing concern across the theatre becomes evident, someone finally makes for the exit, triggering a rush by others. Yet many of those rushing out might not have noticed any smoke. The critical point is reached not because more people notice the smoke; rather, more notice changes in others’ behaviour and thus change their own.

The danger of inflation for economies and financial markets can also be understood in this way. As prices begin to creep higher, a few investors, businesses and households begin to notice. Rather than just going about their business as usual, they begin to watch the behaviour of others more closely. Finally, a handful of economic agents suddenly change their behaviour in a significant and highly visible way, triggering similar responses by others, who might not even have noticed that prices were rising.

What sorts of behavioural changes might those be? Perhaps investors begin to favour assets which protect against inflation. Perhaps businesses take out loans in order to finance stockpiles of inventories, in anticipation of higher prices. Perhaps consumers begin to do the same with durable household goods. By these very actions, investors, businesses and consumers all begin to reinforce a vicious inflationary circle, driving up prices for a broad range of goods. Regardless, once the inflation tipping point is reached, the rush to the exit–to protect against rising prices in some way–is likely to be disorderly and dangerous for the economy, with obvious consequences for financial markets.

Cast your eyes around the globe and it is clear that, in a growing number of countries, tipping points have already been reached. Since early last year there have been occasional food riots in various emerging market economies. The revolutions in Tunisia, Egypt and those brewing elsewhere at present reflect not only a persistent sense of illegitimacy of autocratic rule in much of the muslim world but also the reality of rampant food price inflation in the souk (marketplace). While poverty is always a potential source of instability, when even the nascent middle-class in an emerging economy finds it is struggling merely to put food on the table, it is unlikely that the political order can remain unchanged for long.

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