Guess What's Coming to Dinner: Inflation! (Part Two of Two)
We have suggested in past Amphora Reports that the Fed’s eagerness to expand its current program of POMO Treasury purchases–known in the contemporary financial jargon as QE2 for “quantitative easing round two”–is perhaps best explained by an ulterior motive, that is, to weaken the dollar, thereby facilitating the importation of inflation via higher import prices, including of course commodities but also other imported goods. Now the Fed would not and in fact legally cannot seek to devalue the dollar, as US currency policy resides with the Treasury, not the Fed. But of course Fed policies can have a huge impact on the dollar and, as long as the Treasury does not oppose them, then for all practical purposes, the Fed implements currency policy. In the current instance, if the Fed is indeed seeking a weaker dollar, then the US is rightly considered to have a “weak dollar policy”, in sharp contrast to the “strong dollar policy” which was explicitly followed by the Clinton administration in the 1990s.
This argument is not lost on certain foreign governments. China, Brazil and now also Germany see through the US Fed/Treasury smokescreen. Senior officials of all three countries are now accusing the US of currency manipulation via aggressive and unconventional monetary stimulus. From their perspective, they don’t care whether such policies are instigated by the supposedly independent Federal Reserve or by the US Treasury. The result is that the Fed, as the issuer of the global reserve currency, is flooding the global economy with liquidity. This is causing all sorts of economic mayhem around the world, ranging from asset bubbles associated with so-called “hot-money” foreign capital flows, to soaring consumer price inflation.
Yes, that’s right, soaring inflation. Perhaps not yet in the US, mind you, but elsewhere. Back in April, we explored the topic of rising inflationary pressures around the world and discovered that, just about everywhere, inflation rates were no longer declining and, in some cases, had already risen to levels associated with economic overheating. Now, six months later, with inflation already elevated, there is a major inflationary shock in the pipeline in the form of higher food and textile prices.
Although it may have started as a supply scare associated with widespread destruction by fire of the Russian wheat crop, prices for agricultural commodities, in particular grains, sugar and cotton, have soared over the past few months. Wheat and soybeans are both up by over 30%. Corn by nearly 50%. Sugar by 65%. Coffee by over 30%. Cotton by 60%.
These are huge increases. There is no way that price rises of this magnitude are going to be absorbed by producers in the form of reduced profit margins. No, as the demand for food and basic clothing is highly price inelastic–that is, consumers don’t demand much less of it even in the event of a large rise in price–these increases are going to show up before long on the dinner table and in the wardrobe.
Now it might be the case that, in most developed economies, food comprises, on average, a small portion of the household budget. In the US, for example, the BLS estimates that it accounts for only 14% of median household expenditures (although food prices are generally lower in the US than in most developed economies for various reasons ranging from economies of scale to taxes). In any case, consider now that, say, only 25% of the recent, approximately 40% increase in a broad basket of basic foodstuff prices is passed through to consumers. Other factors equal, this implies that US CPI is going to rise by 40% * 25% * 14% or about 1.4%. But if 50% is passed through, this rises to 2.8%. If 75%, to 3.2%. Households will almost certainly notice, especially when these price increases are set alongside stagnant or possibly even declining wages. Nevertheless, a modest rise in the CPI, even amidst anemic growth, would hardly compare to the 1970s, when the CPI reached double-digits and the word “stagflation” entered the economic lexicon.
But wait: The story does not end there. As mentioned above, the food price shock in developing economies is going to add fuel to their inflationary fires. Amidst healthy economic growth and low unemployment, workers in these more dynamic economies are already pushing for higher wages, sometimes in the form of disruptive and occasionally even violent strikes. Rising wage demands will, at the margin, result in higher production costs generally. Some portion of these costs are likely to be absorbed into corporate profit margins but, naturally, some will be passed on to consumers in the form of higher prices. Also, keep in mind that these dynamic developing economies are precisely those which export all manner of consumer goods to the developed economies, notably the US.
In this way, the US and other developed economies are poised to import food price inflation not only directly, in the form of sharply higher food prices, but also indirectly, in the form of higher imported goods prices generally. Textiles, furniture, hardware, appliances, electronics, toys–you name it–are produced in and thus imported from those very developing countries now facing sharply rising wage pressures. The global food price shock is thus going to become a general imported goods price shock, albeit with a longer time-lag of quarters rather than months.
Now this discussion of the potential for higher CPI in developed economies so far ignores the possibility that, in response to rising wages and inflation, China, India and perhaps other countries become willing to allow substantially more currency appreciation. Although this would hurt competitiveness, so will rising wages in time. And to the extent that these countries, notably China, are net food importers, stronger currencies will go right to the consumer’s bottom line in the form of improved food affordability. In this way, rather than endure wage disputes, labor strikes and other economically and potentially socially destabilizing actions, countries like China could act preemptively to head off such threats. If they do, the rate at which the US and other developed economies import price inflation will be commensurately quicker.
Nevertheless, as discussed above, higher inflation is regarded by the US Fed and, tacitly at least by the US Treasury, as something to be encouraged rather that avoided. Presumably they would like nothing more than to see China and probably other countries allow additional currency strength versus the dollar. Remember, inflation of only 1% a year is somehow “dangerously low”–notwithstanding the fact that the US financial system almost collapsed amidst higher inflation. (As an aside, according to Orwellian Federal Reserve rhetoric, “price stability” is inflation of at least 2%.)
Following the financial crisis, it would be surprising had the Fed not lost some credibility. After all, they didn’t see the crisis coming and, arguably, their actions in the years 2004-07 contributed to it. Looking forward, if indeed the Fed is committed to engineering a modestly higher CPI, are financial markets pricing in such a development? Do they trust the Fed to achieve its policy objectives?
The most straightforward way to observe CPI expectations is by looking at the implied inflation rates embedded in the prices of inflation-linked securities, which in the US are known as TIPS. 10y TIPS prices currently imply a future inflation rate of around 2.5%, which is more or less in line with assumed Fed policy goals. As such, financial markets appear to be pricing in at present that the Fed is likely to succeed in restoring a low and stable rate of CPI in future. Yet this is a highly dangerous assumption, as demonstrated by our discussion of the coming food price shock, its impact on developing economies and the potential for the US to quite suddenly import a substantial amount of inflation from the rest of the world, either via higher world wages, a weaker dollar, or some combination thereof. We find it curious that financial markets seem to imply that the Fed can pull this off. Or do they? There is the possibility that future inflation rates implied by TIPS are, in fact, dangerously misleading.
[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.]