Monday, July 03, 2006

Inflation oversight goes a long way

So the global economy has had broad money supply (M3) growth outstripping money GDP growth since the year 2000. The outcome is not rocket science.
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What happens when there is excess liquidity in the global economy? It is used to purchase all manner of assets, from property, to equities, to bonds, to paintings, to anything and everything. Global aggregate demand for goods and services increases, which creates stiff competition for the limited goods and services available in the economy, resulting in rising prices = inflation.
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The world economy - and certainly the G-10 - has had a liquidity overhang for some time now. Central bankers have been talking about the possibility of this excess money rushing into specific assets, causing outright bubbles (like the dot.com bubble). What has happened instead is that the money has rushed into a broader basket of assets, from the UK to Iceland, US to S.Africa, etc. Following the US Fed reserve's interest rake hikes, global investors are re-pricing risk and rushing their money into the US, to take advantage of similarly high yields but in a low risk environment (arguably risk-free). The consequence of investors quickly closing their investment positions and pulling funds out of one region/asset class, and into another region/asset class overnight is a lot of market volatility. Financial crises can occur in weaker economies and contagion would soon follow.
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Right now we have a lot of market volatility, uncertainty and risk averseness because we have caused it. This does not necessarily imply that we have a danger of recessionary times ahead, it simply implies that the market is (as always) being driven by sentiment, mainly greed, then swiftly followed by fear.
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The inflationary pressure (upward) that is now "terrorising" the minds of many a central banker has been caused by energy prices, commodity prices and too much money running around.
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Solution:
Let it [current inflation] pass through [the economy] because most of its stimulus is exogenous. Be warned about the risks of monetary policy over-zealousness. Central banks cannot remedy externally driven inflation, they can only remedy domestically generated inflation. Right now there is a big push for central banks to be seen taking stances and talking tough about inflation, but if the current inflationary pressure proves to be transitory, big economic troubles will be brought about by central bank over-excitement.

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