Thoughts on Inflation

The Federal Reserve insists that we are in a low inflationary environment but rising energy and food costs appear to contradict that assertion.  Are the problems with rising commodity prices structural, temporary or irrelevant?  

Volatility in oil prices is structural.  The sustained economic vitality of the global economy hinges on the price of oil. The Middle East and North Africa loom large on the horizon for global financial markets. 35% of the world’s oil comes from this region (Russia is now the world’s largest supplier of crude oil at 51%).  The surge in oil prices is not due to disruption in supply. Prices are driven by future expectations and political unrest fuels higher prices.  Oil inventories swelled during the economic downturn.  These are starting to shrink with the recovery of the developed country economies and the amazing growth spurt that Asia is experiencing.  Saudi Arabia has the capacity to make up for any lost productivity in Northern Africa that occurs as Libya works through its political complications. All eyes are on the Saudis to see how they weather the political fallout sweeping the region.  Democracy is not a common form of Arab government.  Out of of 22 Arab nations, 19 are autocracies (i.e. dictatorships). 

Food prices are higher today in real terms than at any time since 1984. The main reasons for higher food costs are weather related and appear to be temporary.  Russia, Argentina and China are in a drought.  Floods have plagued Canada and Pakistan. Supply shocks have led to export bans and rising tariffs to protect existing stocks and farmers.  Biofuels initiatives have also distorted food prices.  For example, ethanol accounts for 8% of America’s fuel for vehicles (due to Federal mandates and subsidies) but consumes almost 40% of America’s corn crop.  It irritates me that I’m paying more for a bag of Doritos because of Federal ethanol mandates.

The Economist’s commodity-price index has risen 39% over the last year.  This index includes food and industrial materials (non-food agriculturals and metals).  Manufacturer’s prices have risen and they want to pass these costs on to retailers and ultimately consumers. Retailers are crafty about raising prices.  A common strategy is to reduce the size of a product while keeping prices the same (more air and less chips in my bag of Doritos for the same price!?).  

Quantitative easing (i.e. printing money) obviously factors into rising commodity prices as well.  The Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England have all been printing money and lowering interest rates for the past two years.  Investors and speculators react to these monetary policies and a common strategy is to buy commodities.  I don’t know how to differentiate or quantify the appreciation of commodities between supply and demand factors and the impact of central banks printing money.

This isn’t the end of the world, it’s just a cycle.  When we see a spike in prices like we have in energy and food, it inspires producers to increase harvests or develop new oil fields to cash in on the boom (drill, baby, drill!).  Often this results in an increase in supply and downward pressure on prices.  

Monetary policy will also change in the next few years.  At some point central banks will raise interest rates in their attempt to navigate a “soft landing” for our economy. This could presage a sharp decline in commodity prices.  Who knows, maybe in the next year or so we’ll be reading headlines about destitute farmers, oil producers and small investors that lost their shirts when the commodity bubble burst… and investors are funneling money back into real estate and condos in Florida!

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Filed under + Economics, Politics and Financial Planning

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