Provisional Truth | Essays | April
21, 2008
Inflation’s Early Warning System
Validated
When we’ve “told you so” and it turns out we guessed
correctly, we especially want to make sure you are well
aware of our forecasting genius.
As readers will remember in our June 23, 2007 commentary
entitled
“Inflation’s Early Warning System” we forecast the
growing inflationary forces assembling in commodities
markets as evidenced by the surge in crude foodstuffs and
feedstuffs prices buried in the May 2007 Producer Price
Index report.
Ten months later, the March 2008 Producer Price Index, the
measure of wholesale inflation, leaped by 1.1% (13.2%
annualized), but the “core” rate, excluding food and energy,
increased only 0.2%. “If you don’t eat and don’t drive,”
quipped a cable TV business info-tainment reporter, “there’s
a lot to like in this report.”
But the surge in grain prices and energy costs since early
2007 have exceeded even our extreme-case scenarios, and we
are beginning to see the downside in headlines around the
world.
Global demand for edible commodities now is translating into
food shortages in various places and speculative fervor in
others, and, based on the developing swiftness in which
shortages are escalating, it appears that while the West has
been fiddling about global warming and climate change,
hunger has begun to burn anew in many parts of the world.
From the March PPI report, crude foodstuffs and feedstuffs
jumped 8% for the month and nearly 24% for the first quarter
of 2008. Year over year, the increase exceeded 31%.
March’s consumer price index, however, released April 16th,
registered a gain of only 0.3% (0.2% core), proving once
again there are “lies, damned lies, and statistics.” (More
on that below.)
But wholesale prices are registering huge monthly
gains again, and ultimately, will flow through the Finished
Goods category and into the Consumer Price Index, that other
great government work of Pulitzer-worthy fiction. (For as
you already are aware, it is in the government’s vested
interest to significantly underestimate the real rate of
consumer inflation because of the big expense of
cost-of-living adjustments to entitlement programs like
Social Security.)
It defies credibility to believe finished-goods inflation of
nearly 7% y-o-y is not being transmitted to consumer prices
unless retailers now are selling everything at a loss hoping
to make up the profits on volume. There is not a restaurant
we have visited recently that does not have a pleasantly
worded sign somewhere near the cash register explaining why
increased costs have forced an increase in meal prices, yet
we are told again and again inflation is under control.
To wit, recently the Department of Agriculture said food
prices grew 4.0% in 2007 (more fiction), the most in 17
years, but ominously estimates 2008 “could be worse” with a
rise of 4.5% (are these guys on the same planet as us?). By
contrast, a recent price tally in the
latest American Farm Bureau
market basket survey of 16 basic groceries was $45.03 in
the first quarter, up 8% from fourth-quarter 2007,
which is far more reflective of the prices we really are
paying.
(Not to digress, but the crack number-crunchers in the
service of our government keep these patently false numbers
low by assuming if the cost of milk, at $4/gallon is “too
high,” then consumers make the obvious choice to substitute
Coca-Cola for milk since Coke sells for about $2.50/gallon
on sale. No actual effort is made to determine if consumers
really substitute Coke for milk or hamburger for steak, or
are forgoing Coke, milk, hamburger and steak in order to
keep the gas tank filled to commute to the jobs they soon
may lose. The real rate of consumer inflation, using methods
abandoned in the 1980s to help fix Social Security and
amended again in the 1990s to further reduce cost of living
adjustments, likely is around 12%, which we
intuitively realize every time we shop or pay bills, but,
again, we digress.)
A safe assumption by this crack number-cruncher is retail
food prices (the real prices that real people pay) in 2008
likely will explode upward in the 12% - 20% range as the
full impact of rising energy prices and global commodity
demand/scarcity becomes visible.
Rising global demand and food shortages have begun to create
hoarding behavior at a government level as commodity and
food exporting countries begin to impose export
restrictions, lest the social unrest attendant with
shortages of any kind threaten their own regimes.
In America, we spend about 15% of personal income on food.
Compared with undeveloped parts of the world whose
inhabitants must devote 50% - 75% of income for food, the
potential for social unrest is enormous. Recent food riots
in Egypt and Haiti recently represent the beginning of this
trend and Haiti’s toppled government may be the first of
many in this chain of events.
Which is why China, with its incredible $1.7 Trillion of
foreign currency reserves, will spare no expense to buy any
and all food and energy commodities necessary to achieve
social peace and tranquility, at least until after the
Olympics in August. (FYI, after the Olympic torch again is
extinguished in late August, and the U.S. and Europe descend
further into recession, the entire country and its economy
may collapse from exhaustion, with much more serious global
ramifications.)
We should begin to see renewed interest in
country-to-country “barter” agreements – your food for our
oil sort of thing – with multiple-year agreement lock-ups
that will further exacerbate commodity price movements.
All of this, in turn, has attracted and continues to attract
a huge pool of speculative money, which, having been created
in the last 30 years of unprecedented money-supply growth,
and having manifested itself in the stock market bubble,
which ended in 2000, and now the housing bubble, which ended
in early 2007, now focuses its attention in commodities
markets as is obvious from the record-setting prices of
gold, copper, oil, wheat, corn, soybeans, rice, and on and
on.
That the treasury bond market and stock market have not yet
reacted to these inflationary pressures clearly is an
indication of extraordinary fear, in the case of the bond
market, driving a so-called “flight-to-quality,” and an
indication of lack of understanding at best and stupidity at
worst, in the case of the still-inflated stock market (our
multi-year low target for the Dow Jones Industrial Average
is 6,800).
Where have all the “bond vigilantes” gone? Those upright,
steely eyed, astute market participants who, back in the
1980s and 1990s at the first whiff of inflation, would begin
bidding up rates and pummeling bond prices to keep the
markets and Federal Reserve in line.
Who today, in their right minds, is comfortable lending the
U.S. government money for 30 years at 4.30%? Someone,
obviously, and obviously a lot of someones, but really: 30
years at 4.30%? Look for a sea change after the November
elections, and in our view, a surge in long-term bond rates,
as the Fed embraces REFLATION as its only solution to this
now-global liquidity/credit crisis.
What Fed Chairman Ben Bernanke describes as “the logic of
the (money) printing press” in the Fed’s all-out war against
asset deflation certainly means further erosion of
the dollar and continuing upward price movement in
commodities, until the commodity bubble, as do all others,
bursts as well.
(A key component will be whether the fast-growing economies
of Brazil, Russia, China and India can sustain internal
consumer demand in 2009 and beyond, and we will find out if,
in fact, these economies are “decoupled” from the U.S. and
Europe, or so inextricably linked that we take them down
with us. For the record, we think global pneumonia – we all
get sick – will prevail in this iteration, which is why we
don’t think China can forsake its role as our banker any
time soon.)
Eventually, because history may not repeat itself but rhymes
on occasion according to Mark Twain, a massive bubble in
commodities and hard assets, as in the late 1970s, may
require the awful-tasting elixir of much higher interest
rates as was prescribed by then-Fed-head Paul Volcker
beginning in 1980 to restore liquidity to the banking and
financial system by making it attractive to extricate
investment funds from a similar commodity bubble. (And yes,
if you had bought 30-year treasury bonds in 1981 with a
14.99% yield, you still would have three years of coupons
remaining!)
Since we’re feeling rather smug about our commodity price
inflation call last year, here’s what we see unfolding for
the next four or five years: a debt-deflation driven
recession with declining overall inflation
(disinflation, not deflation from lower asset prices but
rising commodity prices), followed by lots of big-time
inflation (to inflate away, in real terms, the value our
huge consumer, business and government debt load) as
economic recovery kicks in.
This year and next look for a new millennium version of that
1970s favorite “stagflation” as collapsing residential real
estate prices, job layoffs and debt liquidation will produce
a slow, ugly (NOT mild) economic downturn lasting at least
18-24 months (the “stag-”) in combination with still surging
commodity prices finally beginning to spill over into
general price increases (the “-flation”)
In the intervening years of 2010 and 2011, as the economy
recovers, the stage will be set again for a repeat of the
big-inflation years of the late 1970s and early 1980s, where
wage earners, the true drivers of inflation, will see
multiple-year double-digit income gains, but no “real”
income gains as a surging corresponding general price
inflation, including a rebound in residential housing
values, erodes the benefits of those income gains.
At some point, but not before 2012 or 2013, we will need
another Paul Volcker-type Fed Chairman to take away the
low-interest-rate punchbowl and chase investment and
speculative money out of hard assets and back into a
battered banking and financial system.
This economic roller coaster has the potential to make
whoever wins the November presidential election a one-termer,
like Jimmy Carter and George H.W. Bush, but one thing we do
know for certain, the 2012 presidential election campaign
officially will begin on November 5th.
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