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June 2007

All Roads Lead Through China

By: Allan Seychuk

We live in a world awash in money. Liquidity is at the heart of todayʼs persistently low long-term bond yields, extremely tight credit spreads, and abnormally low volatility. By looking at the ease of buying and selling financial assets, the Bank of England recently calculated that markets are more liquid today than they were at the height of the dotcom bubble in the late 1990s.

All roads lead through China

Liquidity has also facilitated a tremendous increase in asset prices since the early part of this decade. However, one of the most striking aspects of todayʼs economy is the fact that all this money sloshing about has not led to much of an increase in core inflation – that is, inflation outside of food and energy prices. How can this be? And, will it last? Although we donʼt pretend to have the definitive answer, the search for one suggests that all roads lead through China.

Curiously, while no consensus has emerged on how to define liquidity, thereʼs no debating that thereʼs lots of it (See Chart 1). Moreover, there can be no mistaking the impact that liquidity has had on global financial markets. The month of May 2007 brought new record highs for the S&P/TSX, the Dow, and the S&P 500. These gains pale in comparison to the MSCI Emerging Markets Index which has nearly tripled from its 2002 low, powered by staggering gains in Brazilʼs Bovespa (475 per cent), Russiaʼs RTS (535 per cent), Indiaʼs Sensex (390 per cent), and Chinaʼs Shanghai Composite (150 per cent), among others.

All roads lead through China

Last, but not least, we are in the midst of the most pronounced house price boom in history. According to the S&P/ Case-Shiller Home Price Index of the 10 largest U.S. cities, prices are up 182 per cent in the last decade. In Canada, weʼve seen gains over the same period ranging from 80 per cent in Toronto to 100 per cent in Vancouver and nearly 200 per cent in Calgary and Edmonton.

Traditionally, excess money relative to economic activity leads to both asset price inflation and consumer price inflation. In fact, asset price inflation itself tends to cause consumer price inflation because rising demand for assets causes people to try to create more of those assets (and get paid for doing so) and because of the wealth effect where people spend part of their financial profits on more goods and services. However, todayʼs strong liquidity growth and exceptional asset price inflation have not had much of an impact on consumer price inflation at all, outside of energy prices (See Chart 2). With very few exceptions, core CPI in Canada and the U.S. has remained within a one per cent to three per cent band since1994 (See Chart 3). Even overall inflation, while much more volatile, has generally remained within a one per cent to four per cent band over this period.

All roads lead through China

Why So Little Inflation?

Weʼre left with a unique phenomenon of non-inflationary liquidity. Booming asset prices have been accompanied by goods inflation thatʼs been downright boring so far.

There are a couple of potential explanations for this.

All roads lead through China

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