Inflation is largely caused by the insatiable demand for energy and commodities in big, rapidly growing emerging economies. However, to cure the global inflation problem, adjustment is necessary in the economy that is worst positioned to withstand such adjustment, the United States.

Financial markets have a tendency to exaggerate. Most people actually know this, but it was first proved only in 1976 by the late Rudy Dornbusch, a macroeconomist who came up with an economic model describing currency movements containing a feature called ‘overshooting‘. We are in the process of getting some of this in the financial markets at the moment.

Overshooting is generally applicable to most if not all asset prices trading at financial markets where expectations play an important role, and in its most simple form it can be described as follows: when some shock happens (like the housing, credit, and inflation shocks the last year or so), asset prices will react. But they’ll react in an exaggerated way called overshooting (or, in this case, the more appropriate term would be ‘undershooting’).

Why is that? Well, people will sell the affected assets until they become so cheap as to generate expectations that they will rise in price again, only then will people start buying them and their price reductions will stop. This implies that they necessarily have to get to some form of undervaluation.

That this doesn’t bode well for the present situation might be clear:

• As we have argued earlier, if anything (and to our considerable and repeated surprise), asset prices have shown a muted reaction to the serious economic shocks of the last year
• Those economic shocks, if anything, now seem to be even more serious than the consensus view seemed to be a couple of months ago.

In plain terms, the crisis is a lot worse than most people expected and the adjustment in asset prices (that is, stocks) has been muted so far. Hence the large sell-off over the last week.

We have mentioned it here several times, but not only are the housing and credit crisis far from over, there is a new phenomenon that severely curtails the possibilities of policy authorities: inflation.

As we put it in an earlier article; to stimulate growth and employment, interest rates need to be low but to combat inflation, they need to be a lot higher. It’s an awkward dilemma, and it’s answered differently by different central banks.

The European central bank (ECB) is more hawkish on inflation, and so far, they can afford to be because economic conditions are (still) a lot better in Europe than they are in the US, where the credit and housing crisis originated.

So we’ll almost certainly see a rate hike from the ECB shortly. This might actually increase global inflation, as a widening interest rate differential with the US will put the US dollar under further strain. And how is the FED to react? Increase rates in the middle of a worsening economic situation?

Or, not increase rates, and risk seriously compromising it’s credibility? Credibility is the single most important asset of central banks. It takes years, decades to build credibility and it can be destroyed instantly. Credibility works like magic. By tempering expectations, a credible central bank needs actually to intervene much less severely in order to combat a problem, especially inflation (which is, arguably, their main task).

People will expect that the interventions of a credible central bank will be successful, and this belief will temper inflationary expectations, reducing inflation itself. However, if not credible, a central bank need to seriously hike interest rates (and/or tighten other monetary conditions) in order to squeeze the inflation out of the system via demand deflation.

Basically, if central banks are not very credible, only creating a recession will reduce demand enough for inflation to be squeezed out of the system. It’s one of the best kept public secrets that most recessions after the second world war were a byproduct of central banks combatting inflation, with the recession in the early 1980s as exhibit A.

In the present inflationary situation the are two additional problems:

1) Inflation is mostly created in the energy and commodity markets, and this is largely a result of rising demand in emerging economies, like China and India

So, in order to stop inflation, the Fed needs to reduce demand in.. China?

That seems a pretty daunting task, to say the least. Luckily, reducing demand in the US will also reduce:

• The demand for oil and commodities
• The demand for Chinese exports, and hence the demand for oil and commodities.

Unfortunately, reducing demand further in the US through a hike in interest rates would risk putting the economy in a serious recession. The US is too driven by credit and the financial system is too weak as a result, rising interest rates could easily throw it over a cliff.

Unfortunately, there is a second problem attached to the present inflationary environment:

2) A weakening dollar is likely to have significantly contributed to the inflationary environment.

Energy and commodities are priced in dollars, and their rising prices are to some degree just compensation for their falling dollar value. To what degree is impossible to tell, but that the falling dollar plays a role is almost certain.

And now the risk is, if the Fed doesn’t increase interest rates but other central banks will (and already have), this will further weaken the dollar, thereby further boost inflation.

So, we have a paradoxical situation with the following ingredients:

• Inflation is largely produced in the commodities market (including energy)
• It is largely the result of the rising demand for commodities in large emerging markets like China and India
• Funny enough, since inflation largely originates in these emerging economies and these countries would be best placed (economically) to reduce demand by tightening monetary conditions, it is doubtful whether this would actually significantly reduce the problem as:
• Very lax monetary conditions in the US will widen interest rate differentials with the rest of the world and would further weaken the dollar, which in itself is inflationary for the world economy
• It will also maintain demand for a large part of the Chinese manufacturers (those that export to the US), and hence hinder the necessary demand reduction.

The conclusion becomes almost inescapable that the world inflationary commodities boom needs adjustment in it’s largest economy, which also happens to be the economy least able to withstand the necessary demand reduction. A sharp US recession seems to be the price to get inflation out of the world economy.

Welcome to the paradoxes of a modern, globalized economy