A Bourse Diary

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Wednesday, November 16, 2005

Inflation Fears (2)

In earlier times a large part of the inflation was based on structural "problems" - both economical and political nature. Accordingly, in order to deal with the inflation pressure, the Fed reacted (as normal and as today too) with interest rate hikes.
However, in earlier periods the inflation was only to be stopped by driving the interest rates so high till the economy fell into recession, or at least was strongly cooled down. The reason for this were some structural problems: the much stronger position of the trade unions (and the associated inflationary spiral), the higher state ratio to GDP and the lower intensity of competition, missing production capacities in the developing countries, and also very important - the Cold War with all transfer payments into the geopolitically important regions (official and unofficially, also in form of credits, from which everyone knew they are never going to be paid back). This was then neseccary to simply secure strategic interests (which was quite good and correct considering the danger, which went out from the communist block). The list could be expanded...

Therefore stopping of the inflation was possible only by very high interest rates and finally through strong deceleration of the economy, even recession.

Since Reagans's presidency however much happened in America and in the world weaken or solve many of the structural problems. Much was made for liberalisation of the American economy, for more dynamic and less restrictions on the flow capital and investment. Since beginning of the 90's the capital received even more real possibilities for investments world-wide. Many countries provided (and some of them quite successfully) better investment conditions and political security. Accordingly the production capacities and resource of these countries grew (perhaps Asia and China are the most prominent examples, in addition, many Eastern European countries, some South American ones etc.).

Between 1993 and 1994 we had a similar situation like now. The incrasing inflation rate let the yields on the capital market and the Fed rate go up. The stock markets went down fearing coming recession (which was to be expected by experience). But this time it was not necessary for the economy to fall into recession to coll down the inflation. The growth pace dipped a little which immediatly eased the inflation pressueres due to the changed structural conditions (in the USA and world-wide). What followed was one of the greatest bull markets of the history.

Today we witness very similar situation. The main difference are the very low yields on the bond markets. This could be a couse of some concern...

...to be continued...


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