UK inflation for December: 3.7% - QE is creating inflation as I expected.

In the post I published on the 16th of November 2010: "Another Letter from the Governor to the Chancellor - UK CPI at 3.2% in October", I continued to argue that inflation would keep rising in the UK. This post was the continuation of what I foresaw back in February 2010, that QE in the UK would be inflationary. It has been a recurring theme in my posts (see previous posts in April and May as well on why QE is inflationary).

I advised the following in February 2010, the need to track the movements of the CRB index, which could be done via the LYXOR ETF denominated in Euros.
I wrote:
"You need to closely monitor commodities prices because they are steadily going up again as the CRB index is showing. Lyxor CRB ETF denominated in Euros displays this increase: FR0010270033 is the ISIN."

The LYXOR CRB ETF was around 19.5 Euros in February 2010 when I previously posted:

Now the same LYXOR CRB ETF index is at around 24 Euros, a nice 24% increase nearly year on year (if you put the trade on that is...), reflecting the surge in commodities. The Thomson Reuters/Jefferies CRB Index (TR/J CRB) is currently made up of 19 commodities as quoted on the NYMEX, CBOT, LME, CME and COMEX exchanges. These are sorted into 4 groups, each with different weightings. These groups are:

Petroleum based products (based on their importance to global trade, always make up 33% of the weightings)
Liquid assets
Highly liquid assets
Diverse commodities.

In my book we have Stagflation in the UK, inflation, low growth, high unemployment.

"In economics, stagflation is the situation when both the inflation rate and the unemployment rate are persistently high. It is a difficult economic condition for a country, because when inflation and economic stagnation are occurring simultaneously, a policy dilemma results since actions that are meant to assist with fighting inflation might worsen economic stagnation and vice versa."

Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some."

How do you stop inflation creeping up in the UK? Very simple, the Bank of England will be pressured to raise rates sooner than later, because Mervyn King must be tired of having to write a letter to the Chancellor regularly.

Reminder:
The governor must write to the chancellor every three months when the inflation rate deviates more than a point from the central target in either direction...

The RPI figure for the whole of 2010 was 4.6% - the highest rate since 1991.

Below inflation from 2000 to 2010 in the UK:

The Bank of England is indeed in a very difficult quagmire.

The risk of a double dip in for the UK economy is alive and real.

This is what I wrote on the subject on the 16th of November 2010:

"There is still a very real risk of a double-dip recession in the UK. At some point the Governor of the Bank of England Mervyn King will have to raise rates to counter the rise in prices. This will put additional pressure on housing prices as well as mortgages and put more households into trouble, which would impair even more the damaged balance sheets of many UK banks."

And yes, you can have inflation in a deflationary environment:

"The inflation debate or why you can have inflation in a deflationary environment"

About Sovereign risk in 2010 and about the risk of Stagflation à la mode 1970...

In December last year when I first wrote about Greece, CDS 5 year was trading around 260 bps. Now CDS 5 year is trading above 400 bps, and the CDS curve is completely inverted.

As per CMA DataVision, the cumulative probability of default (CPD) is now around 28.55%.

Greece came to the market with a 8 Billion Euros 5 yeard bond issue and the following day of the issue, bonds were trading one point lower. Greece is in trouble. They need to raise another 50 Billions Euros.

Confidence in the Euro currency is getting tested with the situation in Greece and as per my previous post: The importance of being earnest, about the Eurozone in general and the Euro in particular.

">http://macronomy.blogspot.com/2009/12/importance-of-being-earnest-about.html">

There is a risk the Eurozone could implode. Greece is showing the first signs of weaknesses, but Portugal and Spain, are also facing troubles of their own.

We are still in a deflationary environment which could lead afterwards to a period of stagflation in the coming years. Low growth and higher inflation. All the governments are scrambling to tackle the huge deficits they have created and did not control properly.
Take for instance France, the last time the budget was balanced was 1980 and the last time France had an excess budget was 1976 (very good year for wine and the public finances...).

As per Wikipedia on Stagflation, we can see some heery similarities with what we are starting to witness in the current environment.

http://en.wikipedia.org/wiki/Stagflation



Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Keynes explicitly pointed out the relationship between governments printing money and inflation.

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance."

Keynes also pointed out how government price controls discourage production.

"The presumption of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it. A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but leads finally to the waste and inefficiency of barter."

Any similarities with what Venezuela is experiencing at the moment is "purely fortuitous"...

Yes, Sovereign risk is going to be the big theme for 2010.

Everyone is trying to debase their currencies and need to borrow heavily at the same time.

Countries immediately at risk are:
Greece
Venezuela
Argentina

We are facing a crisis of confidence in the system and a crisis of confidence in our governments.
Let's all hope governments will starting facing their responsibilities and make the necessary cuts in spendings and implementation of regulations sufficient enough to pull us out of the hole we have dug ourselves in.