What's the scariest thing out there at the moment?

There are many things out there at the moment scaring markets, and sometimes it’s hard to know which direction to be scared in. During the 1970s and early 1980s what was eventually termed the great inflation gripped America, and double digit price increases wiped out productivity and hindered efficiency. Price controls were put in place to stop companies raising prices. Wage controls were erected to keep companies costs down. Many tricks were played by the government to try and lower inflation without slowing the growth in the money supply, but in the end the only way to slow inflation was a cold hard recession, brought about by higher interest rates and slow money growth. There are many things to be scared about at the moment, but the scariest might be rising inflation in China.

When the Chinese increase the money supply, people find they have excess reserves of cash so they spend more. Business are then selling more, which makes them happy because their incomes rise (this is generally the central bank’s intention). Eventually firms realise they can’t keep up though, and they decide to raise prices to curb the demand. Higher prices do what they always do, and people buy less. Production falls to its original level (but now with a higher price level).

Firms today however are wise to the central bank, and try to predict when there will be general inflation. Why go to all the trouble of increasing production (that’s hard work!) when you can just raise your prices when the central bank prints money. In this way inflation expectations become very important for the central bank. If businesses expect the central bank to print money, no increases in production occur. We’ll just jump straight to higher prices.

Furthermore, because of inflation expectations no actual money printing need occur in China for inflation to take hold. Higher inflation expectations mean firms expect higher costs as input material suppliers raise their prices, plus higher wages negotiated by their employees who think prices will rise. In expectation of these cost increases firms increase their prices. The point is inflation expectations are very important determinants of where inflation is headed, and expectations tend to become self-fulfilling prophecies.

Jump to And the scary part is...