Does the printing of money by central banks inevitably lead to inflation?

Is there good inflation and bad inflation?

Quantitative easing is now underway in most developed countries in some form or other, most notably in the US, UK and Europe. It hopes to make up for the decline in transactions for a given stock of money by increasing the stock of money for a given level of transactions. In fact it hopes to more than make up for it. If successful, what does it create in growth of price level and output? It should result either in higher prices for a given level of output, or a higher level of output for a given price level, or both. While on the one hand the stock of money and rate of transactions are scalar quantities, on the other hand the prices and outputs are vectors whose product is scalar. That means that not only are we uncertain about whether the impact of success of quantitative easing is on price or output, we don’t know which markets are reactive to it. Common sense would imply that capacity constrained markets are more likely to see price inflation as opposed to real growth while the impact in markets with excess capacity are likely to be on output. Income and substitution effects complicate the analysis of the system as a whole. There may be no impact in some markets either in price or output. However, there must be at least one market in which either price or output rises.

Capacity utilization has fallen substantially in most industries and across most regions. The oil industry may be one example of an exception as refinery capacity constraints and an exhaustible resource constrain both upstream and downstream capacity. If quantitative easing is effective in boosting nominal demand, it may manifest in markets like oil. In other industries such as manufacturing, excess capacity is likely to cap inflation. Whether output rises is, however, uncertain. At an aggregate level, however, the scale of excess capacity created in the wake of the 2008 credit crisis is likely to keep aggregate inflation in check while allowing aggregate output to rise.

Inflation is not always a bad thing. It is damaging when it is the result of the debasing of a currency to the extent that there is a loss of confidence or serious erosion in purchasing power. Until such acute levels of inflation are felt, moderate inflation can be a sign of a robust economy. Generally, inflation isn’t a problem unless you can feel it without being told it’s a problem by an economist. You feel inflation relative to your rate of growth of wealth including your return on investment and wage growth.

Expectations as evidenced by the bond markets have oscillated between inflation and deflation. On the one hand capacity utilization has fallen precipitously and on the other monetary policy has bordered on the irresponsible. 

With substantial excess capacity in the economy, fiscal and monetary policies have ample latitude to take effect without triggering rampant inflation. If anything there is risk of deflation which policy makers hope to mitigate. The view is supported by the fact that neither fiscal policy nor quantitative easing has managed to flatten or steepen yield curves to the any large extent. Assuming policy is effective in bringing employment back to acceptable pre crisis equilibrium levels, inflation is likely to settle in the mid single digits, an acceptable place to be. If not, deflation is likely. Given the scale of government intervention, success is more likely.

A by product of stabilizing the real economy through monetary policy is likely to be asset price inflation. In 2001 when the Fed cut interest rates sharply it fuelled an expansion in credit driven by the quest for yield and the availability of cheap credit creating asset bubbles in anything where leverage was feasible – real estate, structured credit, bank balance sheets. In 2008, the tool is not just lower interest rates but quantitative easing which is likely to have a more direct and mechanical impact in inflating markets where capacity is constrained. Commodities, equities, bonds and real estate are likely areas which are likely to face rapid price inflation , already underway. This will almost certainly lead to overvaluation.

The ultimate effect is likely to be period of boom and bust of increasing amplitude in asset markets, more volatility and uncertainty in monetary policy, and finally unstable prices in product markets.

The mark of a great leader is that he or she leaves a company, country or other organization strong enough to stand on its own without their continuing influence or indeed choice of successor. Redundancy is the ultimate test.

Some potentially great leaders do in fact succeed in this respect, yet fail to recognize their own achievement, and thus linger on, often to the detriment of their legacy. For it is true that everyone rises to their level of incompetence. It is no criticism of human ability or human nature, mere a recognition of our limitations.

Inflation/deflation doesn’t turn on a dime. Inflation/deflation expectations turn on a dime.

Time to put on curve flatteners in US 2s and 10s, and 2s and 5s.

In a market known for measured and deliberate and more often than not friendly M&A, the merger between Kirin and Suntory is an interesting transaction. The Kirin Suntory deal is by no means hostile but it is a merger of rivals. The merger if consummated will create the fifth largest food and beverage company in the world. There are several remarkable features of the deal.

The Japanese beer industry is an oligopoly, making the potential merger a remarkable one, breaking a long standing status quo.

Given the size of Suntory, the deal looks more like a merger of very substantial equals rather than a takeover. Working out who will run the combined entity will be an interesting exercise in speculation.

Japan’s Fair Trade Commission will have to approve the deal. Given that the merger is between the number 2 and 3 by market share (out of 4 players), this might present some issues, were it not for the fact that the Fair Trade Commission is pretty powerless.

The two companies employ a total of 59000 employees. Cost savings through layoffs will be politically unpalatable in the middle of a recession when unemployment is already high.

Kirin has been in acquisition mode and in the midst of buying Lion Nathan, a not insignificant cash deal valued at 4.8 billion AUD. Lion Nathan itself is quite highly geared strong debt service ratios notwithstanding. It has 2 pieces of debt maturing 2010 and 2013, of 285 m and 404 m AUD respectively. Kirin itself is less highly geared and has a more distributed term structure. In any case Kirin will have to lever its balance sheet a good 15% to acquire Lion Nathan. Quite what the terms of the Kirin Suntory deal will be will impact the credit quality of the combined entity.

The deal has as usual been telegraphed in the market well ahead of an announcement. No one likes surprises in Japan. Suntory is unlisted, however, Kirin’s share price has traded up on yet undisclosed deal terms.

For risk arbitrageurs, the fact that Suntory is unlisted doesn’t really help a lot, nor the fact that deal terms are yet undisclosed. Hedge ratios in the equity are near impossible to determine. Both Suntory and Kirin have debt in issue which can be used to express a risk arb view although given the track record of credit expressions of risk arb in 2008, it is doubtful if any arbs would be trying that for some time. Also, the Suntory debt is not traded very much and would be hard to source and dispose of in case of deal break.

There may, however, be a capital structure trade. Kirin will most certainly have to gear its balance sheet to digest its latest and potential acquisitions. Kirin’s bonds have traded sharply up in the past month, particularly its 03/2018 and its 03/2020 issues.

That Kirin’s share price has jumped on the news seems to suggest that despite the absence of precise deal terms, this is a bona fide merger as opposed to a takeover, with the balance of power in Suntory’s hands. Its hard to tell given the opacity of the Suntory end of the deal. If Kirin is the defacto target, the deal may be positive for its share price.

A long equity short debt trade might be the way to profit from this transaction.