I noted an article on inflation risk in the FT by someone called Andrew Parlin. To describe him as an inflation fetishist would be fair, but at least he had the honesty to lay bare his fear. He said:
[A]n entrenched inflation such as we have not known in decades and the need to slam on the brakes through aggressive rate tightening [is the risk that exists]. Given how inflated asset prices are, the bust that would follow would probably be unusually severe and protracted.
What he is suggesting is that there aren’t just isolated examples of excessive risk-taking on the basis of asymmetric betting right now, but that the entire financial market is currently built in it. Asset values are, as he is honest enough to admit, utterly distorted. The distortion has been created by low interest rate policy, linked to low inflation.
There is an inverse relationship between both low interest rates and inflation and financial asset prices. If financial assets pay broadly steady returns but interest rates fall asset prices rise to approximately equate the two. If inflation is also low then there is an extra boost for asset prices as lower risk discounts need not be applied. Both situations have existed for so long now asset prices are seriously over-inflated.
Parlin’s naked fear is that this situation might reverse if there was to be inflation, and that to prevent that asset price crash then the real economy must be sacrificed, in his view. Unemployment, austerity, and small-town corporate failures must all become the norm to maintain orderly asset pricing, even when it is recognised that those prices are seriously over-inflated.
Leaving aside questions of desirability (because it is patently undesirable to do this) and necessity (which is doubtful, as the inflation paranoia on display is not based on real-world risk, but on textbook ones instead, and the textbooks are wrong) what Parlin is saying is that financial markets are one entire asymmetric risky bet, all premised on the idea that interest rates will stay low in perpetuity. That may be true. But, when everything else in the economy has to be sacrificed to making good on that bet it is clear that the risk has moved from being routine to asymmetric. In other words, it can only continue to be justified by the perpetuation of the bet itself. That is the logic of the Ponzi, or pyramid selling scheme, of course. And that is where the whole of financial markets are.
The actual quote:
First, the risk-reward of his experiment is wholly asymmetrical, skewed hugely to the downside. If Powell is right, it is unclear what the reward will have been. The downside, however, is incalculable: an entrenched inflation such as we have not known in decades and the need to slam on the brakes through aggressive rate tightening. Given how inflated asset prices are, the bust that would follow would probably be unusually severe and protracted.
That is, the point being made is entirely the opposite. If – if – we allow inflation to rip then the cure will be horribly expensive. So, let’s not allow it to then, eh?