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Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Inflation, Inflation, Inflation Graeme Troy FFA April 2010
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Page 1: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

Inflation, Inflation, InflationGraeme Troy FFA

April 2010

Page 2: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

2

What is inflation/deflation?

Some simple mathematics

Classical Theories

– Inflation falls in a recession

– Printing money causes inflation

– Large budget deficits – Inflation is the ‘easy’ way out

– Risk assets provide good long term inflation protection

The Bank of England – what do they believe?

The General Election

Conclusion

Overview

Page 3: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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What is inflation?

DefinitionThe rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

John Maynard Keynes - EconomistBy a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

Bill Vaughan – US Industry AuthorSome idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as the culmination of your career

Source: http://dictionary.reference.com/browse/inflation, http://thinkexist.com/quotations/inflation/

Page 4: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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UK Inflation Facts

If you put £1 into the Retail Prices Index in June 1947, that would be worth £29.90 today. RPI inflation has averaged 5.6%pa since 1947.

In 1906, 1 pint of beer cost two pence (old money). ‘Beer inflation’ has averaged 5.8% in the last 100 years!

In 1710, a male teacher’s annual wage was £15.78 – approximately 2.5% annualised wage inflation for the last 300 years.

In 1982, the first Sony CD player retailed for 168,000 Yen, approximately £400 then. Today, a standard CD player can be bought for £40 : ‘electronic deflation’ of 8% per annum.

Source: http://privatewww.essex.ac.uk/~alan/family/N-Money.html, http://www.igp-web.com/Carlow/wages.htm, ONS Data, http://www.sony.net/Fun/SH/1-20/h5.html

Page 5: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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What is deflation?

Deflation is a decrease in the general price level of goods and services. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money

JapanThe only real modern-day example where deflation has had periods of persistency

Source: Wikipedia, Bloomberg.

Page 6: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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UK Inflation Measures

RPI – The Retail Price Index- 24% of the index comprises housing: much more volatile than CPI - More common in pension fund liabilities- UK government bonds track this index- Index data back to June 1947

CPI – The Consumer Price Index- Probably the most important in terms of economic policy- BoE charged with targeting 2.0% CPI at a two year time horizon- If current CPI prints below 1.0% or above 3.0%, the Governor must explain this in writing to the Chancellor- Relatively new index (1989)

Other indices- Average Earnings Indices- Big Mac index (Currency/Inflation trade-off, Economist magazine)

Page 7: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Simple Mathematics – Beware ‘Base Effects’!

CPI & VAT: In Dec-08 VAT was cut from 17.5% to 15%, and reversed in Jan-10

Feb-08 Feb-09 Feb-10CPI Index 106.3 109.6 112.9Inflation rate 3.1% 3.0%

So despite negative base effects due to VAT, inflation remained above target in the UK in 2009

0Index

IndexInflationIndex tt

Now suppose a tax change reduces the index by 2% T1 but is reversed T3, with all else unchanged

T0 T1 T2 T3Index 100 100 104.9 108Inflation rate 0.0% 4.9% 3.0%

Inflation over the entire period is unchanged, but T1 and T3 rates have been impacted by ‘base effects’

T0 T1 T2 T3Index 100 102 107 108Inflation rate 2.0% 4.9% 0.9%

Page 8: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Theory 1: Inflation falls in a recession?

Page 9: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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UK CPI during the recession

The Theory

Companies reduce prices to survive

Unemployment – lower demand

People save more, spend less

What has happened

CPI currently > 1% above target

CPI averaged 2.2% in 2009

Petrol prices at all time highs

16 of last 23 prints upward surprise0

1

2

3

4

5

6

Sep-07 Sep-08 Sep-09

CPI Y

oY In

flatio

n

Source: CPI data, Bloomberg

Page 10: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Why has UK Inflation Been So ‘Sticky’?

[1] The CurrencyThe UK is a net importer of manufactured goodsSince 2008, Sterling is down approximately 25% against most of its trading partnersLagged effects from the currency estimated to be roughly 30 months

Source: Currency lagged effects: Michael Saunders, Citigroup economist.

[2] Pricing Power / OligopoliesDuring a deep recession, smaller companies tend to go bustLarger companies enter ‘survival mode’Oligopolies are formed – only a few dominating companies exist (eg UK banking)Companies then can and will push prices higher

[3] Redistribution of WealthThe Base Rate fell from 5.5% to 0.5%Most consumers in the UK have large debts – particularly their mortgagesThe costs of servicing existing debt has generally fallen for most peopleThe majority of people have much more disposable incomeThis is at the expense of the extra 2.5% of people made unemployed

[4] OilGlobally, demand for oil has remained resilient – UK is insignificant on a global scale for oil demandOil is priced in $Oil impacts many areas – petrol, public transport, transportation of food, plastics

Page 11: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Can these pressures fade?

The CurrencyLagged effects from the currency likely to tail off in the next twelve monthsMore confidence after the General Election?

Source: Currency lagged effects: Michael Saunders, Citigroup economist.

Pricing PowerAs the economy starts to recover, new entrants may join the marketIncreased competition should squeeze margins and feed into lower prices

OilOver the (very) long term, slow move toward alternative energies

Page 12: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Theory 2: Printing Money leads to inflation?

Page 13: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

Images past and present

13

Germany 1923Germany 1923 Zimbabwe 2008Zimbabwe 2008

Source: http://www.marketoracle.co.uk/Article5713.html, wikipedia

July-08 inflation rate estimated at 231,150,888.87%July-08 inflation rate estimated at 231,150,888.87%1923 inflation – prices double every two days1923 inflation – prices double every two days

Page 14: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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The quantity theory of money

M x V = P x QM = Quantity of money in circulation V = Velocity of circulation

P = Price Level associated with transactionsQ = Real Growth expenditures (eg GDP)

V , Q assumed stable. So Increasing M => increasing P?

In the UK the BoE printed £200bn – 15% of GDP, between Mar-09 and Jan-10

The assumption that V is stable is critical

Currently V is broken – banks aren’t lending, consumers are saving more, spending less

If V begins to pick up, it is vital M is reduced or V is kept in check

M can be reduced by selling back the gilts it currently owns, issuing new debt

V can be kept lower via fiscal measures / public spending cuts / higher interest rates

Page 15: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Theory 3: Large Budget Deficits => High Inflation?

Page 16: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Early 1970s

Annual budget deficit ran between 5-10% of GDP

RPI was as high as 27%, consistently above 10%

Mid 1990s

Deficit requirement blew out to 6% of GDP

Economic growth reduced deficit, inflation stable

BoE independence 1997 – inflation targeting

Now

£1.3 TRILLION outstanding debt by 2015 (2010 Budget)

Political Uncertainty

Source: Datastream.

Large Budget Deficit => High inflation?

Page 17: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Theory 4: ‘Risk’ assets provide inflation protection

Page 18: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Asset Classes – Inflation Protection?

Gold

– Historically countries used to link their currency to the Gold Standard

– Central banks can print money, they cannot print gold

– Limited supply

Property

– Rents typically reviewed every five years

– Capital values move with affordability – if profits / incomes move in line with inflation, capital values and rents will

move in similarly

The Classical Interpretation

Equities

– Revenues and Expenses generally rise in line with inflation

– As a result so do profits

Page 19: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Starting Points Are Critical

Since 1986

0

2

4

6

8

10

Dec-86 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06

Valu

e of

£1

RPI GOLD (GBP) FTSE A/S Property

2001 to 2009

Source: Bloomberg, Gold spot Oz / GBPUSD, Property = IPD Index

0

0.5

1

1.5

2

2.5

3

3.5

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

Valu

e of £

1

RPI GOLD (GBP) FTSE A/S Property

Page 20: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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The Bank of England

Page 21: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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The BoE

Target 2% CPI two years ahead

Fan Chart shows potential outcomes

Believe key risk is still low inflation

Suggest Base Rates on hold for long time

The BoE Quarterly Inflation Report

CPI projection - constant Base Rate 0.5% and £200bn QE

Source: Bank of England February-10 Inflation Report, SWIP assumption CPI = RPI -0.8%

The Market

Little chance of rate hikes this year

Medium term CPI at 3% - well above BoE

Election uncertainty

Page 22: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Election : Inflation Inflation Inflation?

Page 23: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Spending Cuts / Taxes / Growth

Higher taxes on incomes serve to dampen inflation expectations in general

The economy is a key focal point – in particular how to deal with the deficit. The major parties agree more needs to be done to reduce the deficit, but disagree on the method

Current polls suggest the election outcome is highly uncertain – and so is the economic outlook

Public spending cuts can increase unemployment and reduce inflation expectations

Higher taxes on goods and services (VAT) will increase very short-term inflation, but erode consumer spending power in the medium-term

All these measures are unpopular – the economic environment will depend on the extent of any working majority or levels of co-operation in a hung parliament

Economic recovery plays a key role in reducing the deficit - ideally fiscal and spending measures wouldn’t harm recovery too much

Page 24: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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CONCLUSION

Page 25: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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Asset classes can offer inflation protection over the long term but starting points are crucial

Printing money doesn’t necessarily lead to inflation (though it does devalue your currency)

Inflation doesn’t necessarily fall in a recession

‘Politics’ and ‘Tax’ – may only be worth half a mark in an actuarial exam but their macroeconomic implications can be critical

The link between budget deficits and inflation is not clearcut

Page 26: Inflation, Inflation, Inflation Graeme Troy FFA April 2010.

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A Final Thought

Ronald Reagan – President

“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”

Source: http://thinkexist.com/quotations/inflation/


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