Monty Guild on Inflation

Source: Monty Guild and Tony Danaher | Guild Investment Management

Food inflation as we have mentioned is here to stay. Corn prices may be peaking as the Mississippi river crests, but we see higher prices for other substitutable grains. A decline in food prices could happen temporarily in the autumn if the U.S. Government and others end set their aside programs and other countries start to develop underdeveloped farmland. This will not lead to a large increase in food production worldwide initially but in the long term production will rise.

The problem is that consumption is also rising at a rapid rate. While worldwide production will not go up by a huge amount, the main effect will be psychological. As people come to the conclusion that supplies may increase, speculators will exit positions. Over the longer term, global food stocks will be rebuilt as they are way too low. This rebuilding of inventories will keep prices firm.

As we have mentioned in the past, global food inventories have fallen in 7 of the last 8 years. These inventories must be rebuilt for many years before prices can really start to fall. The fact is, global food prices are lower in inflation adjusted dollars than they were decades ago. Even in the most optimistic case, inflation adjusted corn, wheat, soybeans, and other foods must rise for years to come just to get back to their inflation adjusted prices of 50 years ago.

An aside…developed country consumers spend less of their budget on food compared to consumers in other countries. We believe that this will change. Consumers in developed countries will be spending more of their total income on food as well.

INFLATION WILL COME MORE AND MORE INTO PUBLIC AWARENESS OVER THE NEXT SEVERAL YEARS

There are many indicators of inflation in the world that we watch to forecast oncoming inflation. Currently, the great majority of these tell us that the inflation we have seen so far…is just getting started.

IT IS NOT THE CASE THAT FOOD AND ENERGY ARE THE SOLE OR MOST IMPORTANT DRIVERS OF INFLATION TODAY

The public media has picked up on the theme of inflation in the last few months, and they have been haranguing the public about higher food and energy prices. As a result, many people believe that once the rate of the rise in food and energy prices slows, the rate of increase in inflation will recede.

In our commentaries, we have been talking about inflation and its expected arrival for almost two years. We have pointed out the reasons for inflation, and discussed some of the many variables in a general way. We would like to take this opportunity to discuss them in more detail.

IN TODAY’S MEMO, WE WILL COVER FOUR OF THE TEN REASONS WHY WE BELIEVE INFLATION WILL CONTINUE:

REASON #1: PERIODS OF LONG GLOBAL ECONOMIC EXPANSION CREATE INFLATIONARY TENDENCIES

The economic expansion that began in 2003 was still going strong as the end of 2007 approached. The current banking crisis in the developed world has caused it to slow. However, the economic growth rate did not slow in the developing world, and the tendencies leading to inflation remain strong globally.

Some governments are still trying to tell their constituents that the U.S. and European economies are growing, but at a much slower rate. On the other hand, important economists in both regions agree that the U.S. and Europe are at least in a growth recession…if not an outright recession.

In either case, a slight recession or slow growth, the current economic climate has been strong in the developed world for five years, and in the developing world (which is more important) it has been going on for closer to ten years. China, India, Brazil, Russia the mid eastern oil producers and many other countries continue to grow at a very rapid rate as we write this memo.

IN SUMMARY, APART FROM THE DEVELOPED WORLD, EVERYONE IS STILL GROWING…AND SOME BIG COUNTRIES ARE GROWING VERY FAST. PROLONGED AND INCREASING ECONOMIC GROWTH STIMULATES INFLATIONARY EVENTS IN THE ECONOMY.

Perhaps it is shortages of raw material, skilled labor…or, maybe it is the need for speedy delivery to a customer. Maybe new customers and new markets are all putting pressure on suppliers to achieve rapid execution in getting the deliveries out on time and with good quality…at the expense of price.

IN BOOM TIMES, PRICE INCREASES ARE EASY TO PASS THROUGH. THIS LEADS TO PROFIT MARGIN EXPANSION.

Of course, price increases lead to inflation. In this way, a long economic expansion (such as the one that the world is currently experiencing) will lead to higher prices. When customers’ profit margins are strong, eventually the customers allow their suppliers to raise prices and enjoy higher margins as well. Higher margins come as result of higher prices.

A long economic expansion breeds higher prices, and is the first of 10 influences on inflation. Stay tuned for more about what drives inflation.

REASON #2: GOVERNMENTS ARE QUICK TO ADDRESS THE DOWNSIDE RISKS TO THE BANKS AND THE FINANCIAL SYSTEM. THIS IS DUE TO A NUMBER OF FACTORS, BUT PRIMARILY IT IS DUE TO A CHANGE IN THE PSYCHOLOGY OF GOVERNMENTS REGARDING BANK SOLVENCY AND ECONOMIC GROWTH.

SIMULTANEOUSLY, THEY HAVE BECOME SLOWER TO MOVE TO STOP INFLATION FROM BECOMING EMBEDDED IN THE SYSTEM.

Now that they recognize inflation is becoming a problem, they have begun to address it…but in words only. Thus far, U.S. Federal Reserve has spoken about the possibility of higher interest rates, but they have done nothing. U.S. interest rates are lower now than when the inflation rate was almost 2% per annum lower. Higher inflation should mean higher interest rates, but thus far it hasn’t. The ECB has also recognized inflation is higher than their targets, but thus far has only spoken of instituting higher rates.

Government officials have become afraid to not limit the downside risks to their economy due to social and political pressure. The days of the hard nosed, tough central bankers in the U.S. and many countries has ended. Inflation, which was a specter that stalked the world in the 1970’s, has been pushed to the back of the institutional memory of politicians and bureaucrats who run the day to day activities of government. The days when inflation, and wages adjusted to inflation, caused havoc in the 1970’s are remembered by some of the older financial types, but not by government as a whole. As a result, people in the developed and developing world are slow to act to restrain inflation. This slowness to restrain it causes inflationary psychology to become embedded in the public mind. As we will discuss in future memos this can be a serious problem.

MORAL HAZARD

Another major issue is that the U.S. and Europe have become more social democratic or socialist in the governmental policies in the last thirty years. Thus, an institutional bias by government toward protection of the public at all costs has risen. In other words, the institutional bias that existed in the U.S. in the 1970’s that said that the individual was at least partly responsible for their personal financial future has eroded. In the 1970’s, I do not recall anyone thinking that it would ever be OK for the government to take over a bank like Britain did when it bailed out Northern Rock; publicly stating that it was making good on all deposits…even those well in excess of the insured maximum. In fact, many crises of the seventies were correlated to a major bank failure. At those times, people who had deposits in excess of insured amounts were just out of luck.

REASON #3: GOVERNMENT SUBSIDIES

Today, food, energy and other consumables are subsidized by the governments of countries where about 4 billion of the world’s people live. China and India are rife with subsidies for food, energy and other goods…as are many dozens of other countries globally. These subsidies are a mistake and will create inflation when they are lifted.

Governments subsidize the price of food, energy and other consumables for political purposes…it is a good way to curry favor with voters. These have been a favorite with centrally planned economies for decades. Their history goes back much further to some of the world’s ancient civilizations. There has in my opinion, never been a track record of long term success for these types of programs. Politicians are attracted to them because they are popular with consumers. The programs cut costs for consumers, but someone has to absorb the loss on the subsidy. Usually, it is the taxpayers or the owners of companies who are asked to lose money on the goods that they sell to consumers at below cost.

For example, if world prices of gasoline are $4.50 per gallon and you can buy gasoline for $2.00 per gallon in Vietnam, why would you not purchase gasoline for $2.00 and resell it in another locale (a neighboring country) at something closer to the world market price of $4.50? The answer is that many people will, and this leads to over-consumption, black markets, shortages, smuggling and many other socially unattractive side effects. Higher prices ration demand and lead to lower consumption artificially low prices incentivize consumption. Eventually, shortages and rationing follow…and the government is then forced to move the subsidized price closer to world prices. By now world prices will be much higher than the subsidized price thus setting off a wave of price inflation.

Subsidies are a shortsighted strategy to “improve” the standard of living for their constituents, but they encourage waste and inefficiency…and eventually painful adjustment when they are lifted. Subsidies often lead to inflation and redistribute wealth from the government or the rich to the poor. Once the cost becomes too expensive for the government to bear, or when the private companies who have been forced to sell at below market prices go broke, prices are forced to rise rapidly. The price rise hurts those who have not learned to conserve…often more than they would have been hurt if subsidies had never been introduced.

REASON #4: PRICE CONTROLS

Along with subsidies (which we discussed yesterday) and tariffs (which will be covered in our next memo), price controls are a common but destructive economic tool. They are politically motivated and substitute the intelligence of bureaucrats for the intelligence of the marketplace by telling companies and individuals the prices they can charge for goods and services. Often, the prices are slow to reflect cost increases, and companies and individuals can experience losses and dislocations in profits if the price controllers are not proactive, effective, and accurate.

The way they hurt an economy depends upon many variables, like whether they are all-inclusive, whether they are instituted in concert with wage controls, how much free trade the world and the country enjoys and so forth.

Like subsidies and tariffs price controls cause a misallocation of resources, non-economic behaviors on the part of the government, and antisocial behavior on the part of the public.

Price controls often go hand in hand with: shortages, conniving behavior by businesses and consumers, declines in production, declines in quality, and many other problems. A common problem in price controlled economies is that capital will not be invested to grow businesses because a fair return on capital can not be obtained. So, the manufacturing and employment capacity of the economy will usually fall. This may have the unintended consequence of slowing economic activity and increasing unemployment.

Price controls cause the creation and growth of bureaucracies to administer the controls. These bureaucracies often develop lives of their own and become difficult to remove, causing the controls to last years longer than they should…which further diminishes economic growth.

The biggest problem is that price controls cause a build-up of unfilled price increases and diminished production (people don’t produce for a loss if they can help it). When shortages and economic dislocations caused by the controls finally become politically unpalatable, and politicians remove the controls…INFLATION ACCELERATES.

These make up reason #4 why inflation will be here for a while, and why it is not being driven solely by food and energy price rises.

We will discuss more of the reasons we believe inflation will be with us for a while in next week’s letter. In the meantime, we hope you are enjoying the summer season.

If you would like to read more on inflation please check our website periodically for this series on inflation.