The Inflation Tipping Point (Part Three of Four)

[Continuing from Part Two…]

Alongside the evidence that credit deflation reversed into inflation around mid-2010, we also notice that commodity prices began to rise sharply around this time. Moreover, in most parts of the world, consumer price inflation began to pick up noticeably and by year end had reached the highest levels in years.

At this point, one can quite easily draw parallels with the massive surge in global commodity prices which occurred in the first half of 2008, immediately prior to the arrival of the global financial crisis. (More on this below.)

Commodity prices are once again rising rapidly in the US and elsewhere

The evidence is thus rather clear that the entire monetary transmission mechanism, from narrow to broad money; from broad money to credit and asset growth; from credit and asset growth to commodity and consumer price inflation; is now functioning. Indeed, it is functioning perhaps almost too well as one economy after another approach an inflation tipping point.

In this context, it is perhaps curious why the Fed remains so steadfastly committed to its Treasury bond purchasing program known as QE2. The official, current Fed position is twofold: First, inflation–at least based on how they prefer to measure it–is undesirably low; second, unemployment is undesirably high. As such, the Fed will most probably continue with QE2 and, if this does not change this situation in the coming months, consider expanding or extending the program. (Indeed, we consider this more likely than not).

In our view, the real reason why the Fed continues to stoke the inflationary fire may have more to do with the still-perilous state of the US financial system and the massive debt overhang which, naturally, needs to be serviced. It is much easier to service a debt which is depreciating quickly in real terms, even if it is growing in nominal terms. The Fed may claim to be aiming for just slightly higher inflation but it is possible that they are, in fact, seeking a significantly higher rate to shore up the banking system.

With informed observers of all kinds–investors, businesses and consumers–now smelling the inflationary smoke of rising commodity and consumer price inflation, the Fed’s continuing, unwavering commitment to create inflation could at any moment lead to dramatic changes in behavior. Once the tipping point is reached, the Fed will have lost the ability to control inflation without raising interest rates to punishing levels that will cause a major recession and possibly a financial crisis greater than that which struck in 2008. Why?

Consider how rational economic agents are likely to respond to the onset of clear and present inflation. Prices are already rising and the Fed has not shown the remotest willingness to reconsider its current policies. Investors, therefore, will keep right on chasing returns in asset markets, seeking to remain ahead of the inflation curve. Businesses will stockpile inventories of real assets in an attempt to do the same. Finally, households may begin to stockpile consumer goods. What will be the combined result of these activities? Well, by driving up demand for all manner of assets, and wholesale and consumer goods, they are going to exponentially reinforce the price inflation already underway.

As this sort of demand is not for consumption, but rather for stockpiling or hoarding, it is not positive for growth but rather quite the opposite; it is, rather, economically inefficient and stagflationary. Real consumption is not going to increase. Indeed, as prices rise, it is going to fall. Amidst structurally high unemployment, real wages are also going to fall.

To be continued in Part Four of Four…


John Butler,
for The Daily Reckoning

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]