Inflation’s Early Warning System Validated

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 16^th, 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.

Here’s what we see unfolding for the next couple of 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 Fed/government-sponsored REFLATION (to inflate away, in real terms, the value of our huge consumer, business and government debt load) as an eventual economic recovery kicks in.

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”)

The boom in global commodity prices likely is still in the early stages. China will be the wildcard as its authoritarian regime must avoid widespread social unrest at any cost, and since it has ample currency reserves, mostly U.S. dollars, it will be willing to purchase food and fuel at any price, which further will perpetuate the commodity inflation cycle.

The severity of our recession and our own social discontent 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 5^th.