Inflation

Just as successful parasites are careful not to kill their hosts, governments often are successful at anesthetizing their citizens against the ongoing pain of inflation.

For example, the U.S. Consumer Price Index (CPI) now stands at over 200 from its 1982-1984 base value of 100. This indisputably means the dollar has lost more than 50 percent of its purchasing power since the end of the first Reagan administration — in an era often termed disinflationary. Nonetheless, you will hear Federal Reserve officials congratulating themselves on their monetary mastery.

Still, Americans have much to be grateful for in this regard compared to their Mexican brethren. Comparing the purchasing power of a January 1973 USD and a January 1973 MXN (both adjusted by their respective consumer price indices) shows the MXN has lost so much purchasing power that we must use a semi-logarithmic scale traversing four cycles. It has lost 99.98 percent of its purchasing power in the floating exchange rate era. The USD’s loss, which requires only a single logarithmic cycle, looks like the gold standard in comparison.

If runaway inflation such as this is prima facie evidence of too many pesos chasing too few goods and services within Mexico, it should stand to reason each MXN must exert a proportionately weaker claim on goods and services outside Mexico. All else held equal, we should expect the MXN to have weakened against all other currencies whose inflation was less than Mexico’s over this period.

It shows this decline has occurred, but it has not been smooth and continuous. The MXN’s history has been one of sudden and catastrophic declines, often coinciding with Mexico’s six-year presidential election cycle. The arrows in there mark the 1976, 1982, 1988 and 1994 elections; the one exception to this cycle was the 2000 ouster of the long-ruling Institutional Party of the Revolution (PRI) by Vicente Fox. As of early February, no disruption of the MXN has occurred with the election of incoming president Felipe Calderón.

This long-term chart of the MXN requires the same four cycle semi-logarithmic scale required to depict Mexican inflation. Pesos became worthless both internally within Mexico and externally on the foreign exchange market at about the same percentage rate.

We can overlay the history of three-month MXN forwards on this long-term chart; unfortunately, the data for volatility begins only in 2000. This volatility, which represents the cost of insuring a MXN position, remained high during the latter stages of the global bear market in equities into 2003. Investors feared a repeat of the 1997 Asian experience, when capital fled emerging markets and produced simultaneous major declines in currencies and equities.

Volatility remained high during 2002 -2004 for another reason. As major central banks, led by the U.S. Federal Reserve and the Bank of Japan, flooded the world with cheap money, investors began to move out the risk curve in search of yield: They could borrow cheaply in developed markets, from Japan in particular, and lend in markets such as Mexico. As the Asian crisis was only a few years in the rearview mirror, the more prudent of them purchased options as protection from a catastrophic devaluation.

Volatility often is a contrary indicator. As more investors buy put options on the MXN, potential selling pressure on the currency is reduced in proportion. The option holders no longer feel as if their only recourse is to sell and sell quickly at the first whiff of distress. Accordingly, if volatility on the MXN declined substantially, the contrarian response would be to get short the MXN in a complacent market.