Don’t be Fooled: Inflation is Here

This article originally appeared on Frumforum.com on March 2nd, 2011

http://www.frumforum.com/dont-be-fooled-inflation-is-here

David Frum has recently released a series of calls to the GOP to get off the faux inflation kick.  The argument seems to be that inflation is more of a bogey-man whipped up by some hard asset hawks like Ron Paul and their libertarian disciples on Fox and other outlets.  His and some FF contributors’ arguments against inflationary concerns are tied to the perceived verdict of the bond market, and the notion that the rally in crude oil prices are fanning the flames of unnecessary fears through anomalous price action.

First, it has been argued that the bond markets as expressed in the TIPS  spread are showing little concern. The observation is that the TIPS to vanilla Treasuries spread has significantly narrowed, indicating that fears of inflation have dissipated in the markets.  But this spread comes on the heels of an unprecedented period of turmoil in which the mandates for gravitating towards the safe haven of treasuries and the sense of security they provide could be driving yields down.  These factors could also be creating a liquidity premium in favor of these instruments as TIPS are more difficult to exit without slippage due to lack of a liquid buying pool.  Like all spreads, sometimes the action of one leg relative to the other tells more a tale than the action of the spread itself.

There is another market besides bonds however.  Commodities futures — whose very label implies a forward outlook.  And they argue quite strongly for increased prices where it really matters.  As the commodities markets across a wide spectrum of products show us (below), those who invest in the raw materials that are essential to our daily lives certainly do not see prices falling any time soon.

This leads me to another argument against slaying a supposedly non-existent inflation dragon: that the price of crude oil, so much in the news, is distorting our view of overall prices.  Says Frum: “But a surge in the price of one good, no matter how important, is not an ‘inflation.’ Inflation is a sustained and general increase in the price level, not an alteration in the relationship of prices to one another.”

This is all well and good if upward price action were indeed just limited to energies.  But the fact is commodities all across the board—many of which are stripped out of the core inflation index due to their historical volatility—have been on a relentless rise that can be more aptly labeled a trend rather than a spike.  Here are a few samples of the levels of commodities as reflected in exchange-traded futures. These prices impact the day to day lives and purchasing power of every person, rich or poor, employed or out of work, single or married, rural or urban. These are roughly the front month prices of various commodities over the course of just one calendar year ending today.

Heating Oil +44%
Natural Gas (-19.3%)*
Crude Oil +23%
Gasoline +32%
Wheat  +76%
Corn  +88%
Soybeans +30%
Oats +74%
Canola +46%
Live Cattle +21%
Lean Hogs + 13%
Pork Bellies +46%
Milk +18%
Gold +25%
Silver +100%
Copper +31%
Platinum +17%
Palladium 81%
Cotton +141%
Orange Juice +15%
Sugar +45%
Cocoa +21%
Coffee  +46%
Lumber +17%

Get the idea?  The rise in prices is not an isolated market event but rather a phenomenon that impacts anyone who must drive a car, take a plane, train or bus, eat, drink, buy appliances, or clothing, or even grab a cup of joe, etc.  In other words, live a daily life.

Is this, as Bill O’Reilly might scream, evidence that an evil cabal of “nefarious speculators is manipulating the markets and driving up prices at the expense of ‘the folks’”?  Every single one except natural gas?  First of all, supply/demand is what drives commodities prices both lower and higher.  As natural gas—the one commodity bucking the trend—shows, that rule still applies for there is an abundant supply of the product — and most important, it’s secure within the safe confines of the US and Canadian borders.  (Those who point out the fundamental oversupply of WTI crude in the USA ignore that we import 60% of our daily consumption needs).  There are no Qaddafis or octogenarian Saudi princes with their hands on the natural gas valves.  So supply remains constant and unthreatened.   And where are those evil speculators?  Oh, they’re in natural gas too.  But they are selling into over-supply, driving prices down.  Speculators in commodities go short with the same ease as they go long (no uptick or short stock rules, very low margin) so their bets are purer than in equities.  There is no built-in mechanism to create a long bias.  And still they are saying up and up.

And honestly, from a real world standpoint, does it really matter to a family on a limited budget if “core inflation” (which strips out food and energy, indeed their two highest and most unavoidable monthly expenses outside their mortgage) is low?  All they know is the cost of gasoline is higher, bread is higher, meat is higher, cheese is higher, clothing is higher, milk is higher, cereal is higher, the utility bill is higher, that new refrigerator they need is higher, etc.

At the risk of over-simplifying, three factors are causing price trends to increase.  First, as discussed, supply/demand dynamics are in favor of the latter over the former across the globe as economies improve and world populations, especially among the middle class in developing nations, increase.

Second, regional instability has had a large role in rising prices, be it due to political unrest in the Mideast (crude), to natural disasters in commodities rich regions such as flooded Queensland Australia (coked coal for steel production, sugar and wheat).  More than ever, local prices of goods and services are tied to global developments far over the horizon.

Finally, although monetary policy takes a back seat to supply/demand and unrest when it comes to the latest round of raw materials purchasing, the price of commodities, after falling sharply during the height of the financial crisis, began a relentless march higher in almost lock step with the Feds quantitative easing policies that flooded the markets with cheap dollars.  The past twelve months alone has seen the US Dollar Index fall -4% (-14% over five years) which certainly has not helped ease the upward pressure on dollar-denominated assets.

Remember, it is in Bernanke’s interest to downplay inflation by pointing to core price indicators.  But more than ever there is a disconnect between the form fit data and the day to day costs of just living.  From December of 2008 to the present the CRB index is up 75%.  At what point do price “spikes” become trends?  When do we accept that we are in a new era of de facto inflation, if not the traditional “core” definition.  Oil, for example, was already at the $85-90 range before the Tunisian uprising. It’s rise began in earnest last year after the Fed embarked on its QE2 monetary easing policy.

Far from being a windmill against which the Don Quixotes of Ron Paul and the libertarian-leaning pundits and talk-radio hosts are snapping their spears, inflation as felt by the consumer is very much real and thus a legitimate political issue to be addressed.  The Wall Street Journal recently offered a glimpse of the obvious that is nonetheless lost on the inflation doves tethered to an economic measurement rather than what is happening to Americans’ ever-lightening pocketbooks: “As higher prices flow through the pump and grocery store, middle class Americans are poorer than they otherwise would be.  They feel poorer too—which effects their confidence in the larger economy, and in Mr. Obama’s economic policies.”

Maybe some on FrumForum who have hopes for GOP ascendancy should take this into account before dismissing inflationary fears out of hand as mere hyperbole.