The Inflation Tsunami (Part Two of Three)
Notwithstanding our critical view of Japanese economic policy described in part one, clearly they did not bring the recent earthquake and tsunami upon themselves. The same cannot be true of western governments and central banks, which bear full responsibility for the credit crisis of 2008-09 and the counterproductive policy responses implemented in its aftermath. Having sowed the monetary wind with a massive expansion of the money supply in 2008 and early 2009, they are now reaping the inflationary whirlwind, as recent commodity, producer and consumer price data make increasingly evident.
While any informed observer is aware that commodity prices have risen sharply in recent months, not all may have noticed that commodities also have strongly outperformed the equity markets which, until recently, were also in a clear uptrend. The Dow Jones/UBS broad commodity index has risen by 23% in the past six months and by 28% over the past year, in comparison to the S&P500 equity index, which is up by only 16% and 12%, respectively, over those periods. An outperformance of commodities versus equities is a characteristic of a generally inflationary environment, as was observed during the 1970s, for example.
Evidence that commodity prices are pushing up producer prices is increasingly evident, yet a look behind the headline data indicates that much more inflation is coming through the pipeline. US PPI y/y is currently rising by 5.6%, but that for intermediate goods stands at 7.8% and that for crude goods at 15.9%, clear indications that pipeline inflationary pressure is building. Producer price inflation in most other parts of the world is also picking up. In Europe’s largest economy, Germany, it has risen to 6.4% y/y, notwithstanding the recent strength of the euro.
Consumer price inflation, now at 2.1% y/y, remains relatively subdued by comparison. But that is to be expected as CPI lags developments in commodity prices and PPI, sometimes by a year or more. The relationship, however, is clear. There have also been two unusually large back-to-back m/m increases of 0.4% and 0.5%, respectively, an indication that a surge in consumer price inflation is now underway. This is not lost on US consumers, who perceive that inflation is picking up. For example, according to the Conference Board, consumers currently expect inflation of 6.7% by next year, a large increase from an expectation of 5% in mid-2010 and well above the 10-year average. This rise in inflation expectations is arguably more economically damaging than inflation itself. While inflation results in misallocated resources, it is when inflation expectations become entrenched that the potential for economic ‘stagflation’ grows. Rather than engage in normal commerce, economic behavior begins to change in ways which are inefficient. For example, businesses and households seek to hold larger inventories in anticipation of rising prices. But by withholding goods from circulation, the overall economy becomes less efficient, devoting more resources to storage rather than production, trade or consumption of goods, the basis of sustainable economic activity and growth thereof.
With specific reference to the US, there can be no clearer sign that inflation expectations are surging than when the Head of US Operations of none other than WalMart, Mr Bill Simon, makes a public statement that inflation is rising and that his firm has no choice but to raise prices. WalMart played a major role in consumer price disinflation over the past two decades, as China and other cheap producers came on line and exported their way to economic power, yet it has now called the end of the great disinflation and, drawing on the widespread evidence cited above, demonstrates that the ‘tipping point’ of inflation has been reached. The inflation tsunami is rolling across the economic landscape as we write.
So far, the Fed seems rather oblivious to this development. Indeed, the Fed keeps right on inflating as if it is not doing enough. One look at the recent surge in base money growth–the only form of money under direct control of the Fed–suggests that, at first glance, the Fed actually believes that it needs to add further liquidity to the already enormous inflation tsunami it created back in 2008-09. Perhaps the bureaucrats know something we don’t. Or perhaps they are making yet one more mistake in a long series of mistakes. We leave it to the reader to interpret the chart below and draw their own conclusions.
US base money growth has surged by over 20% year-to-date.
The Fed will soon have a mighty struggle on its hands to keep inflation, both actual and expected, under control. But this presents it with a dilemma: Either confront rising inflation expectations with sharply higher interest rates as Paul Volcker did in 1979-81, thereby triggering a deep recession amidst already high unemployment; or allow such expectations to become entrenched both at home at around the world, such that the dollar loses its pre-eminent reserve currency status, implying a far lower purchasing power than that which obtains today.
The Fed must either take the economy off of life support to save the dollar or keep the economy on life support and watch the dollar–at least as we know it–die. But let us not forget, this dilemma is entirely of the Fed’s own making, the inevitable result of a long-held inflationary bias, colloquially known as the Greenspan/Bernanke ‘Put’, that is, the implied bail-out for excessive risk-taking that has existed in theory ever since the Fed came into existence in 1914 but which was applied repeatedly in practice under Chairmen Greenspan and Bernanke, with Lehman Brothers proving the largest material exception to the rule.
There are those who, in the face of soaring money supply growth and inflation, believe that the Fed is in fact entirely comfortable with a somewhat higher inflation rate as this will help to erode the enormous debt burden carried by the US economy following the colossal housing and credit bubble of 2003-07. Perhaps. But we don’t think it matters whether the Fed is deliberately creating much higher price inflation or not. In either case, the rest of the world is not going to sit idly by and watch the Fed further destabilize the global economy. One country after another is taking action to try and insulate themselves from reflationary Fed policies.
Along these lines, China and India continue to raise interest rates, as do many other smaller economies. In a related action, last week Brazil announced it was imposing a 6% tax on foreign purchases of domestic bonds, as a way of reducing so-called ‘hot-money’ flows, that is, those seeking higher yields in Brazil relative to the US, Japan, Europe and other places where yields are historically low.
Such actions are a form of capital controls. It is a sign of the times, to be sure, that in a recent commentary, even the International Monetary Fund, historically no fan of capital controls, argues that there are, from time to time, situations in which they might play a constructive role. But for every capital control action there is an equal and opposite reaction: Constraining or otherwise distorting the flow of capital implies, in due course, constraints and general distortions on the flow of trade. You can’t have one without the other. And what is negative for global trade is, by definition, negative for global growth. The screws on the Fed’s printing press are tightening both at home and abroad. Beyond a certain point, additional growth in the US money supply will have next to no impact on real growth, only on nominal growth, as real goods are increasingly withdrawn from circulation, resulting in pure and immediate inflation.
When that point is reached, it is game over, checkmate. Sadly, in this game, there are no winners.
[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.]