The story of Inflation in the 21st Century - the run-up and the way-forward

July 13, 2022By chetan

The article has been copied from LinkedIn profile of Sanjeev Kumar.

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My price and inflation predictions have been on target. One of those very rare occasions when one is not happy to be proven right !!!

As I had narrated earlier, the currently ongoing inflation event is the result of the liquidity splurges that the politicians and central bankers across almost all the countries of the world have been indulging in since the 2008/2009 market crashes. During this period, central bankers, who are supposed to be arch conservative, talked up Quantitative Easing (QE) as a panacea for all economic ills. And politicians were only too happy to oblige in the printing and distribution of money. When one spends money that one does not have but borrows (prints) and spends it, at some stage reality will bite in. Initially, it is cool!!! Spending someone else's money and getting high!!! When too much money starts chasing not matching volume of goods/ services, the prices invariably goes up, till goods and services become unaffordable, demand slackens and markets head for a course correction. We are currently in this painful course correction mode across economies of most countries of the world and across most asset classes.

Among these, three asset classes require special mention in this context.

The regulated credit markets have turned frothy with the incredible amounts of near-free money printed and distributed by the central banks of the world and the resultant credit expansion at incredibly low pricing in the formal credit markets. While the regulated credit markets are transparent, nobody knows the true extent and status of the financing that has happened in the shadow banking sector. It will not be very far from truth to assume that quite a few of the deals in this sector were levered and closed only because of the availability of huge liquidity pools at near zero cost. Now with central banks talking increasingly of Quantitative Tightening (QT), liquidity is going to be drying up, which in turn will result in surges in cost of credit. As the cost of credit skyrockets, how many of these levered transactions will unravel is anyone's guess. Suffice to say, there is bound to be serious spilling of blood in this asset class. Going by market buzz, almost all of the large pension funds and development financial institutions of the world have serious direct and indirect exposures into this market. And this can aggravate the deleterious effects of the unraveling of the regulated and shadow credit markets.

The second is the oil markets where the crude prices have been scaling new highs almost every day. While the unexpected V shaped recovery of the global economy post-Covid lockouts played a part in this price rise, the ineptitude of the current US administration has been equally culprit in this wayward price rise. Oil prices are market driven. Markets move on sentiments, real or perceived. Three factors, real as well as perceived, have conspired to drive sentiments hugely negative in this sector. The US administration had a role in each of them. In no particular order of importance, the shutting down of Keystone pipeline, the freeze on the drilling for oil in new Alaskan areas and the shrill rhetoric against the Saudi Government, who are the de-facto leaders for the largest oil pool globally, (without a serious appreciation of the ground realities of the extent of the reliance of the global economy on oil and the time required for scaling to size of an alternate energy generation infrastructure) have driven sentiments negative leading to doubling of the oil prices in the 18 months that this US administration has been in office.

The third is the housing markets. The residential real estate markets have been facing acute strains compounded by two factors viz. mortgage rates climbing over 5% for the first time in decades in the US markets along with sharp rises in cost of residential properties globally. These factors have taken residential real estate beyond the reach of most new entrants into the job markets.

While the three markets mentioned above are the most critical, almost every other asset classes have also een abnormal price rises during this period .

What next ? How much longer can the prices in the various asset classes keep rising ? This is very easy to answer. With QT on the way which will lead to reduced liquidity and higher interest rates, the prices will fall in the near future. The seriousness with which the central banks embrace QT will determine the pace, fury and size of the unwinding of the markets.

This leads us to the next question. How far will the markets fall ? It is my reckoning that prices across all asset classes will revert to the 2005-06 levels from where the asset prices have had a relentless march upwards - barring the sharp V shaped fall and recovery during 2008-09 market crisis and the Covid crisis - driven by the central bank driven liquidity surges and near-zero interest rate policies. Is it crystal ball gazing on my part ? Not so. I am convinced that with a serious QT on the way, the markets will have to re-find the levels before the global markets were flooded by the central banks with artificial liquidity. Unless, of course, the politicians or the central banks lose their nerves along the path of QT because of the pain it will unleash. One is acutely aware that the world currently lacks leaders like Ronald Reagan and central bankers like Paul Volcker.

And how fast (or slowly) will the markets recover from the fall? It is a given that the markets will fall and that the fall will be sharp. Already the equity and several other asset markets across the world have corrected a fair bit. In fact the American equity markets have fallen just a bit short of 20% and are correcting around that level. It is my reckoning that the markets will correct from this level further and sharply more than 50% from the peaks already achieved. After this fall, where do the markets head ? The markets will recover but that recovery will certainly not be the V shaped recoveries one saw in 2008-09 and around Covid. Largely because there will be no central bank waiting to pump in huge surges of liquidity into that systemically abused market which is correcting from these excesses. Rather it will be more like the long and steady recovery we saw during the late 20th century. A whole generation of us are grateful beneficiaries of that growth. One can only hope and pray that our generation also produces leaders like Ronald Reagan and central bankers like Paul Volcker !!!

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