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.

Not Your Father’s Deflation

What heretofore has been billed as a “liquidity crisis” involving some sub-prime mortgage fallout, then a “credit-crunch” as lending standards become tighter, looms larger now as a potential “debt-and-solvency crisis” with the passing of investment house Bear Stearns at the end of last month (with attendant rumors and whispers of “who’s next?”).

In a maneuver reminiscent of the creation of the Resolution Trust Corporation to hold toxic real estate waste from the S&L crisis of the early 1990s, the Federal Reserve is setting up a $30 billion junkyard to hold and – eventually – sell the most noxious elements of the former Bear Stearns’s assets (now with a $1billion first-loss put to JP Morgan Chase as punishment for having to renegotiate the “done-deal” of March 16^th).

As asset values continue to fall, particularly real estate and stocks, as consumers rediscover frugality, and as a quickly slowing economy stagnates (Fourth Quarter 2007 GDP slowing to 0.6% from 4.9% the previous quarter), the Fed is not only following its deflation-fighting playbook but apparently calling some audibles as well. (See “Deflation: Making Sure ‘It’ Can’t Happen Here,” remarks by Dr. Ben S. Bernanke, Nov. 21, 2002.)

The Fed knows as asset values decline, related debt values stay the same and slow a timely economic recovery. It’s the story of the Great Depression, of which Dr. Bernanke is an expert: asset values plunge, existing debt remains, new debt creation is impeded, unemployment surges, consumer spending plunges and business investment languishes and the economy seizes.

The New Deal solution in the 1930s was to REFLATE the economy by devaluing the dollar 40 percent (by revaluing gold to $35/oz. which gave banks significantly more ability to lend under the then-in-force gold standard) and by government employment programs funded with deficit spending (the creation of new money, described by Dr. Bernanke as the “logic of the printing press”).

A generation later, cost-push price inflation of the 1970s gave way to a deficit-spending, Fed-induced program of wage inflation in the early 1980s as employers were forced to bid up salary and benefit packages and labor unions won generous cost-of-living concessions, resulting in annual wage growth in the 15 percent to 20+ percent range for a number of years.

In the midst of the current deflation, however, some of the older implements in the Fed toolbox may not prove to be as effective, namely massive deficit spending, but the long-term goal – reflation as a means of restoring the economy – remains the same, and we can expect the Fed to continue to embrace the logic of the printing press to accomplish this objective.

Anecdotal evidence of economic slowdown, perhaps recession, emerge daily in various parts of the country as economists, financial pundits, astrologers and other guessers attempt to parse the mountains of conflicting data now pointing every direction – commodity prices way up, stocks mixed, bonds up, real estate down, unemployment creeping upward, and on and on.

This economic event – perhaps not your father’s stagflation – appears to be unfolding much more slowly than wishful thinking believes prudent, and those troubled sectors of the economy thought “contained" six months ago, in retrospect, may only have been the opening pitches of the first inning of a very long game. And since, as with baseball, “it ain’t over ‘til it’s over,” extra innings cannot be ruled out of the realm of possibility. (Japan’s economic malaise is by some accounts in its seventeenth year.)

Our thought, more gut feeling than a conclusion validated with empirical data and continuing the sports analogy, is that if the economic event unfolding before us was a baseball game, the collapse of Bear Stearns last month would somewhere near the end of the second inning. So now we’re at the top of the third, and, as always, good pitching beats good hitting, which is why the forces of recession so far are holding on to a no hitter. First quarter corporate earnings are due in earnest by mid-month, and continued write-offs by financial institutions largely will determine the inning’s course and likely the rest of the game.

To date, financial institutions have written down about $150 billion since mid 2007. Where does it end? It’s a moving target, but the numbers keep getting larger, ranging from $500 billion to $3 trillion worldwide depending on the mood of the prognosticator and the willingness (and ability) of the Federal Reserve to continue backstopping those institutions deemed “too big to fail.”

Losses of these magnitudes ultimately are deflationary as asset values are peeled away and protracted reduced consumer consumption leads to the “stagnant” component of stagflation. The inflation element – big-time, 1980s-like wage growth – comes later should the Fed decide – again – the only way to solve a debt crisis is to inflate it away.