Monday, December 20, 2010

Inflation, here is thy sting

Last Thurday, David Rosenberg wrote a headline entitled Inflation, Where is Thy Sting? (subscription required). He outlined his bull case for bonds by showing the chart below of core CPI and went on to comment that there are many disinflationary and deflationary forces at work in the economy.

The mistake that economists like Rosie and central bankers make, IMHO, is to look at core CPI, or the Consumer Price Index ex-food and energy. Inflation is happening in hard assets, i.e. commodity prices. QE2 is blowing a hard asset bubble and it is precisely this blinkered view of measuring inflation as inflation ex-inflation that created the conditions for the last financial crisis.

My Inflation Deflation Timer Model defines inflation as commodity inflation. It is in commodity and hard asset prices that we see inflation. Take a look at the point and figure chart of the CRB Index, which shows the reflation in commodity prices much more clearly.

Inflation stinging in emerging market economies
The sting of inflation is showing up in the emerging market economies, where rising food prices are stinging the consumer. (Oh sorry I forgot, food inflation isn't inflation!)

China has a de facto USD peg and that policy means that, in the absence of other action, US monetary policy is Chinese monetary policy. The tsunami of liquidity that the Fed loosened on the markets is washing up on Chinese shores, where it has resulted in see-through buildings and empty cities (see the satellite photos here). What's more, all that liquidity sloshing around has fueled a boom in Chinese antiques, where stories of record prices paid for an antique vase and for jade carvings abound.

That is where inflation is stinging. Asset bubbles never end well. The latest round of QE is just a case of pouring gasoline on the fire.

Commodity prices are the canaries in the mine
Eventually, Rosie will be right. I wrote before that today's conditions feel like late 2007/early 2008. Tactically, we are seeing a commodity price blowoff and world stock markets are rallying. For now, the path of least resistance is up.

Commodity prices are the canaries in the mine. The CRB is facing a technical hurdle of double-top resistance. How that chart pattern resolves itself is an important "tell" of where the markets move in the near term. Longer term, should any of the economic timebombs blow up, the path of commodity prices will also be an important important signal of the market direction, of whether it is a Dubai-event to be shrugged off or a Russia event that brings down the house of cards.

1 comment:

Geoff said...

Good post!

There are lots of things that could be said, but the one point I would like to make is regarding inflation. I don't have a reference for this but my understanding is that during the 90s the inflation calculations in the United States were modified such that the new calculations presented a significantly lower level of inflation than before the revisions. This is not necessarily a concern if it was done properly. However, I have always wondered if there was a bit of political influence to try and make the numbers look good by making inflation look better than it actually was. Or perhaps circumstances that lead to the revision have now reverted to what they were previous and the revision is no longer appropriate. Either of these scenarios would result in understating inflation and provide false re-assurance to economists. I am not aware if there are other measures of inflation apart from the government's published numbers, but long-term numbers from a different source would make an interesting comparison.

If there really exists a stealthy inflation that economists are not aware of it then there is the potential for some less desirable outcomes in future economic scenarios. Perhaps commodities can provide a more reliable measure of inflation than government numbers since commodity prices are more transparent. Knowing the importance of commodities to a given economy would then enable another measure of inflation to be calculated.

It's not good to apologize during a presentation, but here goes.... I'm not an economist so this is just my humble understanding. Hopefully this adds something to the discussion.