Inflation Why To Worry Or Not

Deutsche Bank
Private Wealth Management

Inflation: Why Worry, Why Not to Worry,
and What to do if You‘re Worried

Marshall Gittler
Chief Strategist, EMEA
Place des Bergues 3
CH-1211 Geneve 1
Switzerland
marshall.gittler@db.com
+41 (0) 22 739 0463

May, 2011

Inflation: Why Worry
Central banks‘ real policy rates at or below zero

Hyperinflation Deflation

— Central banks around the world sharply reduced their policy rates in response to the 2008 financial crisis, in
many cases to zero. After taking inflation into account, the real policy rate is at or below zero in most
regions except for Latin America.
Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

Deutsche Bank Marshall Gittler
Private Wealth Management 2011 Family Office & Wealth Management Conference 2

Major central banks expand their balance sheets


— In addition to reducing the price of money, central banks have been aggressively increasing the quantity of
money available by pumping up their balance sheets. This increases the supply of reserves that banks hold,
which eventually should increase the amount of bank loans and hence the supply of money.
Source: Bloomberg Financial LP, Bank of Japan, Bank of England, Swiss National Bank, Deutsche Bank Global Investment Solutions


Narrow money supply is rising, broad money just starting


— The growth in narrow monetary aggregates, which the central banks control, came down sharply after its 2009 spike, but
has started to recover again.
— The broad aggregates – which the market controls – have also been recovering since the beginning of last year, but are
still well behaved. Large-scale inflation is not likely unless these broader aggregates start to rise sharply as well.



Narrow money supply is rising, broad money just starting

Monetary base and M2 in the US and Eurozone

— We can see this difference particularly in the US and in Europe. The monetary base (MB), which consists of banks‘
reserves at the central bank and cash in the hands of the public, has soared because of the extraordinary
―quantitative easing‖ in which central banks buy bonds from the market, However growth in the broader aggregates,
which represent money available for spending, is still relatively tame.
— In the US, M2 is defined as M0 (bank reserves at the central bank plus notes and coins in circulation) plus deposits in checking accounts (M1) plus
money in savings accounts, certificates of deposit up to $100k, and money market accounts. In Europe, the European Central Bank defines M2 as
M0 plus overnight deposits, deposits with maturities of up to two years, and deposits redeemable with notice of up to three months.
Source: Fed, ECB, Deutsche Bank Global Markets

Inflation has followed broad money growth in US
Broad money growth and inflation over time in the US

— What would happen if broader monetary aggregates start to rise more rapidly? The relationship between the
rate of growth in broad money and the rate of inflation in the US is well established over long time horizons.


The same relationship holds across countries
Broad money growth vs inflation in several countries

— This relationship is not unique to the US. It also holds in a wide variety of countries.

Source: iMF, OECD, Deutsche Bank Global Markets


Inflation is also a fiscal phenomenon, not just monetary
US and UK inflation, 1750~present
15 Fiscal monetisation Volcker
Consumer price inflation (% yoy, 11 year ma) during WWI clamps
Fiscal monetisation down on
10 Napoleonic wars: US UK
during WWII inflation
US war of deficit monetised
US civil war
independence
5

0
Fiscal monetisation
-5 during Vietnam War;
1st industrial revolution: 2nd industrial revolution:
oil shocks
productivity-led deflation productivity rebound; Depression
-10 gold finds
1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000

— Inflation is not just a monetary phenomenon. Historically, when governments have run up big debts (usually
due to wars), they have resorted to inflation in order to diminish the burden of paying back that debt.
Source: Deutsche Bank Global Markets Research


How debt/GDP ratios have been reduced in the past

1. Economic growth
2. Substantive fiscal adjustment/austerity plans
3. Explicit default or restructuring of debts
4. A sudden surprise burst in inflation
5. A steady dosage of financial repression that is
accompanied by an equally steady dosage of inflation

Source: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10


Financial repression and the US post-WWII debt

The US govt engineered negative real rates to reduce its debt
— The US had significant debts left after WWII.
Strong growth helped to reduce these debts, but
financial repression also played its part.
— Financial repression included:
— Interest rate ceilings on deposits, which
induced investors to hold govt bonds.
— Regulations to ensure that govt debt played
a dominant role in domestic institutions‘
asset holdings, particularly pension funds
— High reserve requirements for banks
— Restrictions on the international movement
of capital and on gold holdings
— Overall, low nominal interest rates
(below nominal GDP growth) and
inflationary spurts resulted in negative
real interest rates
Source: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10


Inflation is politically easier than taxation

Hyperinflation
Only in taxation do people discern the Deflation
arbitrary incursions of the state; the
movement of prices, on the other hand,
seems to them sometimes the outcome of
traders’ sordid machinations, more often a
dispensation which, like frost and hail,
mankind must simply accept. The
statesman’s opportunity lies in appreciating
this mental disposition.

Friedrich Bendixen, German economist
and banker (1864~1920)

Source: Robert Hetzel, “German Monetary History in the First Half of the Twentieth Century”
Source for photo: Wikipedia


Fiat money makes it easier to create inflation
UK price index through the ages (log scale)
Hyperinflation Deflation think that modern
— Don‘t
central banking will
prevent a reoccurrence
of this phenomenon. On
the contrary, modern
central banking and the
invention of fiat money
(as opposed to money
backed by precious
metals( has made it
easier for central banks
to debase the currency.
— If we look at Great
Britain, prices rose 10x
in the 600 years from
1300 to 1900. They rose
100x in the following
century, and most of that
has occurred just in the
last 65 years since
WWII.
Source: SG Securities,, “Popular Delusions,” 27 May 2010


Government monetization of debt causes hyperinflation

Weimar inflation caused by soaring monetary base Argentina did the same more recently

Notes: Data normalized with 1913 equal to 1. Observations are the natural logarithm. The
monetary base is cash in circulation plus commercial bank deposits at the Reichsbank.

— From the end of WWI to 1924, the price level in — Argentinian inflation, already running at 500% a year
Germany rose by almost 1trn times. by 1989, soared to 20,000% by 1990 as the
monetary base rose 12,726% a year at its peak in
— In 1913, total currency in Germany was 6bn marks.
early 1990.
Ten years later, a loaf of bread cost 428bn marks.
— The cause of this inflation was monetization of debt — Something that cost 1 cent in Jan 1988 cost $76 just
by the central bank, the Reichsbank. four years later.

Source: Robert Hetzel, “German Monetary History in the First Half of Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions
the Twentieth Century” 13

Banking crises often result in inflation as well

Inflation and external default 1900~2006

— A banking crisis is typically followed by external default. External default is typically followed by inflation.

Source: Reinhart and Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” http://www.nber.org/papers/w13882.pdf?new_window=1


What is the actual inflation rate?

Government changes in calculation method reduce stated inflation rate

— The US government has
changed the way it calculates
the inflation rate 24 times since
1978.
— If it were still calculated the
same way it was done in 1980,
it would be closer to 10%.
— Technological improvements
help to hold down the rate of
inflation, but you can‘t eat an
iPad.

Source: Courtesy of www.shadowstats.com


Inflation: Why Not to Worry
Economists are not looking for rapid inflation

DB Global Markets model of inflation based on economists‘ forecasts

— Economists are not looking for a major rise in inflation. A model of inflation that uses the year-ahead forecasts
of inflation based on the Survey of Professional Forecasters suggests that inflation is likely to accelerate but
remain below 2% next year in both the US and the Eurozone.
Source: BLS, Eurostat,, Deutsche Bank Global Markets


Difference between then and now: the demand for money

Rates soared in Argentina… …but have collapsed recently

— As the money supply soared in Argentina, interest — This time around however interest rates have fallen
rates soared too, with 1~2 month deposit rates even as central bank balance sheets have doubled.
reaching 1,650% a year in 1989 (when inflation was
1,233%). — While the supply of money is soaring, the demand is
collapsing. Thus the price is also falling.
— The market broke down completely for a time in
1990 as inflation soared to over 20,000% a year.



QE does not actually increase the supply of money

The composition of the private sector‘s balance sheet changes, not its size
Before Fed buys bonds from the market

Bank ABC Fed Treasury
Reserves 50 Deposits 100 T-bills 50 Reserves 50 Money 45 T-bills 50
Loans 20 Capital 10 T-bonds 0 Public goods 45 T-bonds 40
T-bonds 40

After Fed buys bonds from the market

Bank ABC Fed Treasury
Reserves 90 Deposits 100 T-bills 50 Reserves 90 Money 45 T-bills 50
Loans 20 Capital 10 T-bonds 40 Public goods 45 T-bonds 40
T-bonds 0

— Quantitative easing does not cause any change in the size of the private sector‘s balance sheet, only the
composition. It exchanges interest-bearing bonds for non-interest-bearing reserves. So in fact QE may be a net
drain on the private sector‘s funds (in that it reduces interest income).
— The Fed‘s balance sheet does expand, as does the composition. But it is not new money being injected into the
private sector; it is merely being swapped for an asset that was previously created (and the money already
spent by the government). So net financial assets do not change.
— There is no effect on the Treasury‘s balance sheet.
— The duration of the publicly held bond market is changed.
Source: Deutsche Bank Global Investment Solutions


We expect only modest inflation in the developed world

DB inflation forecasts

— We expect inflation to remain under control in the developed economies. While it might rise slightly above the
Fed‘s 2% target in 2011 and 2012, we expect this will be largely due to energy and commodities – underlying
inflation should remain under control.
— In the emerging market countries, we expect inflation to come down in Asia in the second half of the year and
for inflation in all regions to be lower in 2012 than in 2011.
Source: Deutsche Bank Global Markets

Chinese inflation likely to slow in 2H

Food inflation peaking Money supply growth has slowed

— Rising inflation in China has been driven mostly by — Money supply growth has also come down sharply
higher food prices. over the last several months under government
— However, food prices have come down in the last pressure.
few weeks, leading us to expect that inflation is — The lagged effect of these efforts should help to
likely to peak in the next few months and fall in the bring down the rate of inflation as well.
second half of the year.



Nonetheless, even low inflation has a big impact over time
Value of money under various inflation regimes

— Nonetheless, it doesn‘t require hyperinflation to make a dent in the value of your portfolio over time. Even small
levels of inflation will slowly eat away at the real value of your assets.
— For example, with 1% inflation you effectively have only 90% of your money left after 10 years. If the inflation rate
rises to 3% -- not that high, really – the amount would be reduced to 74% after 10 years.
— And at that rate, after 50 years the real value of your assets would be worth only 22% of what they were at the
beginning. The central bank would have taken 80% of your money away, bit by bit, without your hardly noticing it.

Source: Deutsche Bank Global Investment Solutions


Inflation: What To Do About It if You‗re Worried
Nature of the two types of inflation

Correlation between growth and inflation Expected vs unexpected inflation

— Growth and inflation are typically positively
correlated. During such times, risky assets can — The main risk to a portfolio is from inflation
perform well. shocks or ―unexpected inflation,‖ which can
— However the correlation does not always hold. change‘ views on the relative merits of
Sometimes there is stagflation, sometimes different asset classes and change discount
inflation falls even as growth accelerates. rates. There is little correlation between
expected and unexpected inflation.
Source: Deutsche Bank Global Markets Research

22

Impact on assets of an inflationary shock
— According to an IMF study1, the response of different asset
classes to inflation varies over time. This means that the
optimum portfolio in response to rising inflation must be
Inflation shock elasticities* rebalanced dynamically as the economy and markets
adjust to the change.
— By asset class, the results of the IMF study were:
— Cash: Cash returns increase with inflation, but the response
is gradual and less than complete. Over the long run, cash
has not fully compensated for the increase in prices. That
could be different in the future if central banks take a more
active stance against inflation.
— Bonds: Long-term bonds are the worst performing asset
immediately following an inflation shock as yields increase.
After about three years though, the dynamics gradually move
in favor of long-term bonds as real yields rise.
— Equities: Equities have not protected against inflation in the
long run. Equity returns decline immediately after an inflation
shock and do not recover meaningfully after that. This makes
them the worst performing asset class over the long run in
Years after the inflationary shock response to an inflationary shock. This is not to say that
equities underperform other traditional asset classes in real
*Defined as the percent change in the asset class total return or price index divided by the
percent change in inflation. An inflationary shock is defined as a one standard deviation
terms over long horizons, just that they may not offer much
change in the month-on-month rate of inflation (0.2 percentage points). protection during periods of rising inflation.
— Commodities: Commodities have been the best performing
asset class when inflation was rising, but the long-term
effects of inflation cause commodity prices to fall gradually,
1Source: Roache, Shaun K. K. and Attie, Alexander P., Inflation Hedging for Long-Term Investors (April either because of rising real interest rates or slowing output.
2009). IMF Working Papers, Vol. , pp. 1-37, 2009. Available at SSRN: http://ssrn.com/abstract=1394810
— This study did not include real estate or index-linked bonds.

23

Equities are not as good an inflation hedge as believed

Equities vs unexpected inflation: negative
correlation Larger inflation shocks cause worse returns

— A little bit of inflation can be good for equities. The price/earnings
— Equities are not always a successful hedge ratio (P/E) in the US has generally been highest when inflation is
against unexpected inflation. In fact, there is a 1%~2%, followed by 2%~3% (the range that we expect).

negative correlation between unexpected inflation — But as inflation climbs, forward P/E ratios start to decline. This is
and equities (i.e., the greater the unexpected because the company‘s real return on equity (ROE) falls as the
replacement cost of its assets rises and accounting depreciation
shock, the worse equities do. falls below replacement cost. Nominal returns rise, but real returns
fall. The market sees through this problem and assigns a lower P/E
Source: Deutsche Bank Global Markets Research. “Unexpected inflation” is defined as the difference
ratio to stocks as inflation rises.
between 1yr ahead US inflation forecasts from the Survey of Professional Forecasters with realized yoy
inflation.
— But a moderate rise in inflation – as we expect -- tends to cap the
upside for stocks, rather than introducing any downside.

24

Commodities have hedged against unexpected inflation

Commodities vs unexpected inflation
— The correlation between commodity
returns and inflation has been positive,
with high commodity returns associated
with high unexpected inflation.
— Of course, this correlation will hold when
inflation shocks result from high
commodity prices, as happened in the
1970s and some people fear may be
happening now. But the relationship
does not appear to be stable across
inflationary regimes.
— Commodity returns tend to be much
more volatile than inflation, making it
difficult to predict how the two will move
together.

Source: DB Global Markets Research

25

Property can hedge against inflation if rents can rise

— DB Global Markets‘ research has shown that property returns are
Property vs unexpected inflation positively correlated with inflation, although the correlation is weak.
This suggests that property can be a partial hedge against inflation.
However property is illiquid and suffers from large transaction
costs.
— Other research1 has shown a difference based on the type of real
estate. Retail property tends not to provide good inflation
protection, because renters have a hard time passing along price
increases to customers and therefore landlords find it difficult to
raise rents.
— Offices on the other hand have provided protection against both
expected and unexpected inflation. Residential property was
even better, probably because home owners have market power
and can raise rents, given that there are few substitutes for
housing.
— Real estate equities however are no better than other kinds of
equities at protecting against inflation. On the contrary, the
Source: DB Global Markets Research, Bureau of Labor Statistics, US Census Bureau, Bloomberg correlation between real estate equities and inflation is negative.
Finance L.P.
Total return on property = price return + rental yields – maintenance yield.
This may be because interest rates tend to rise when inflation
rises.
*1 Demary , Markus and Voigtlander, Michael, “The Inflation Hedging Properties of Real Estate: A
Comparison Between Direct Investments and Equity Returns,” Research center for Real Estate
— Another paper2 concluded that as acceptable risk levels rise,
Economics, Institut der deutschen Wirtschaft Koln, Germany. Available on the web at timberland supplants commercial real estate as the primary
http://eres2009.com/papers/5Dvoigtlaender.pdf
allocation to real estate in a diversified portfolio.
2Waggles, Doug and Johnson, Don, “An analysis of the impact of timberland, farmland and commercial
real estate in the asset allocation decisions of institutional investors ,” Review of Financial Economics,
Vol. 18, Issue 2, April 2009

26

Index-linked bonds vs nominal bonds: a matter of timing

IL bonds outperform in unexpected inflation — As mentioned earlier, long-term bonds are the worst
performing asset immediately following an inflation
shock as yields rise. Eventually though real yields rise
and nominal bonds begin to perform again.
— The graph shows that conventional bonds outperform
index-linked (IL) bonds when inflation is below
expectations, but IL bonds outperform when inflation is
above expectations.
— Over the last 13 years, there has been little cumulative
difference in the total return from the two. Long (5~10yr)
IL bonds have returned 146%, vs 149% for conventional
bonds, with nearly the same volatility of returns.
— The optimal strategy would be to move into IL bonds
early in the inflation cycle and shift back into nominal
Source: Deutsche Bank Global Markets, BoA/Merrill Lynch
bonds once real interest rates start to adjust.
— Developed economies issuing IL bonds: — The current environment is one where actual inflation
has exceeded expectations and hence is a negative
— US, UK, France, Italy, Germany, Greece,
inflationary surprise. Comparing our forecasts with the
Japan, Sweden, Canada, Australia, Israel
market consensus, we expect inflation over the next two
— EM countries issuing IL bonds: years to be largely in line with market expectations and
— Brazil, Mexico, South Africa, Turkey, Poland, therefore offer no further negative inflation surprise. We
Chile, South Korea, Uruguay therefore cannot recommend TIPS at this point.

27

Where to put your money: a diversified portfolio
GIC recommended asset allocation (as of 26 April)
— Given that there is not one
investment that can be
guaranteed to provide a positive
real return in an
inflationary/rising interest rate
environment, we believe the best
course of action is a diversified
portfolio.
— We present here our Global
Investment Committee‘s
recommended asset allocation
for the ―average‖ client.
— Of course, each investor has his
or her own needs and
preferences and so this general
portfolio would have to be
tailored to their specific
requirements.

Source: Deutsche Bank Private Wealth Management


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