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Inflation shock could come from anywhere - Myron Scholes
May 18, 2018
"In the short term I think that major risks ahead are basically what central bankers around the world are going to do," the academic said visiting Sydney this week. "The markets are very unsure whether the central bankers are going to get it right, are they going to be able to increase interest rates at the pace that would keep the economy growing and not cause us to go into recession, or not cause us to go into inflation. "My worry is that their expertise is so imperfect in that dimension that we're either going to have one or the other occurring."
"I'm not a prophet or a see-er," he said. "My thinking is that the major issue is on the inflation side is what really happens with oil and scarce resources, not so much what happens on the workers side achieving higher compensation."
"Oil prices can go up dramatically especially with things happening in the Middle East and the large lack of investment in oil and oil production. Also another aspect of what I see is there might not be so much inflation in the United States, but it's the fact that China is starting to export inflation." The real rate in China was about -1.5 per cent, Dr Scholes said, and pollution reduction policies would fan domestic inflation that would spread globally.
Dr Scholes conveyed that he is not as confident in the prospects for US wage inflation, because of the impact of robotics and automation, despite the labour market being tight.
It is instructive to look at previous cycles to understand why commodity booms and busts happen, "but the problem is it may not tell you anything about what's going to happen now going forward so we have to think about a fresh start, we have to think about new things". That made macro forecasting difficult.
Still, historical data provides the basis of an algorithm or a road map that remains the best predictor of the future. "I think since the crisis of '08 some of them are trying to come into the view that maybe our models are too certain," Dr Scholes said, referring to central banks. "There's been recent work in maybe thinking that it's necessary to start with uncertainty right from the start and realise the world has a lot of uncertainty and the models we're building have no financial sector in them, and basically a lot of crises tend to come about because maybe what's hidden right now – where are today's bubbles, and if there are bubbles."
"When shocks occur, everything becomes highly correlated." He referenced the quote made famous by another Nobel Prize-winner, Harry Markowitz, who coined the phrase diversification is the only free lunch in investing. "It's not free in the sense that when you need it it's gone, when you have all these shocks all the growth assets tend to behave as one."