The recent correction in the commodities markets may be providing Bernake, Geithner and their easy money acolytes with a sense of relief given the relentless run up in prices of raw materials since the announcement of QE back in 2008, but they should not sleep tight just yet. As anyone in the markets will tell you, when any underlying commodity has a price move so vertical in its trajectory it’s bound to face a correction as the smart money, having gotten in for fundamental reasons much earlier along the trend line now wait for the panic buyers or the Johnny-come-lately’s to give the rally that last unsustainable spike to unload their longs and leave the suckers holding $40.00 silver in their purses.
So one must step back and take a long view. Although it would appear that those of us who warn that inflation is not just a threat but very much a fact of life now were knee-jerk pontificators jumping on the commodities rally trend for political (read: Fed/Obama bashing) reasons, the analysis is quite sound. Most important, it is methodical not emotional as price surges tend to make investors and analysts from time to time.
Here are some facts: even with the inevitable correction in commodities, as of this writing crude oil is 35% more expensive than it was a year ago…advancing with ups and downs along the way from as low as $17.50/bbl in November of 2001 to its current level of over $100/bbl or around a 19% annual appreciation in a decade since the Fed started giving away dollars. In that same year silver is still up 93% Wheat 84%. Cotton 100% Coffee 55%. Cattle 10%, etc. In that same decade the USD index against all currencies shed 40% of its value. Gold is up 22% for the year. More revealing, the most precious metal and most stable of exchange mechanisms is up an astonishing 450% since 2001. Put another way, whereas the dollar was worth 1/250th of an ounce of gold in 2001, it is now only worth 1/1500th. Money can be printed with much more ease and speed than gold can be mined.
To understand why the Bernake’s and Geithner’s of the world view CPI through rose-tinted glasses we must remember who they are. They are wonks who have spent their entire careers lecturing and/or fidgeting with economies without actively participating in them. They are awash in data and are hardwired to extrapolate patterns from the past to predict the future. But we have only had a non-gold fiat monetary system in place since 1971 which is hardly enough time to get a handle on repeating macro-economic cycles in such an ever changing and dynamic landscape. And I want to offer something else. From the late 1940s to the mid-1980s the United States was the dominant manufacturer in the world. The reason? Of our three main foreign competitors today, China, Japan and Germany, one was mired for much of the third quarter of the 20th Century in a disastrous experiment with Maoist communism while the latter two’s urban centers had been reduced to utter wasteland as their reward for launching the most devastating war in human history. Indeed, all of Europe was digging out of the wreckage of their mass-fratricide, including a bankrupted Great Britain…once the supreme power of the world.
Into that void poured American made cars, radios, appliances, garments, food, you name it. By the mid-1950s the US was producing almost half of the world’s manufacturing output. Now we produce less than 20%. So when Bernake considers whether or not rising prices will result from printing trillions of dollars he looks back to, say 1987 when the dollar index halved yet CPI was only up 4.4% in that same year. Ergo: a falling dollar does not cause inflation. Hence QE I and II should move forward without fear.
But he is wrong on two levels. First of all, a weak dollar is usually a catalyst to prompt more exports as US goods become cheaper. And indeed that has happened as the manufacturing sector has been recovering nicely. But, those US manufacturers that once dominated the landscape are few and far between as we have surrendered our assembly lines to the forces of cheap labor overseas in favor of a service oriented economy. So now when imported goods are more expensive due to their relative strength (or less weakness) against the dollar, unlike in the past when we could shift our purchases to cheaper US-made goods, we instead are compelled to accept higher prices as we have no choice but to buy foreign-made goods. Ask Wall-Mart. (One’s house would be an almost vacant four walls if we invaded it and took away any items that don’t say “Made In USA” on them!) China, for example in 1987 produced less than 5% of the world’s goods. Now it almost a 20%. A four-fold increase.
Secondly, the definition of inflation that most people use, including the Fed, seems to be a measure of the CPI as if the two are interchangeable. Hence, people believe, if the CPI remains steady, so too does inflation. But, what is inflation exactly? Is it really price increases per se? Or are rising prices just one symptom of a larger event? “Inflation” is what the word implies: an inflation in the supply of a currency and thus a decrease in its value and eventually its purchasing power. Consumer prices are not always the best measure for a variety of reasons. Just to give one example, they tend to be ‘sticky’ in that vendors are hard-pressed to jack them up to account for lost dollar values. So they may try other approaches to mitigate the inflated currency’s impact on the bottom line such as keeping prices the same but reducing the package size. Care for some potato chips with your bag of air? How about a 1.5 pint of ice cream that for the same price (hence no measurable impact on CPI) that used to be 1.75 pints? There are many ways short of raising prices to compensate for the effects of an ever expanding supply of dollars. But real costs rise just the same.
The fact is that inflation in its traditional definition is rampant across the globe and it can in large part be attributed to the policy of almost zero interest rates in the form of a greatly expanding balance sheet of the Federal Reserve. Take China for example. They are the largest exporter to the United States and as such have a vested interest in preventing their products from becoming too expensive (although they have less to fear from competitively cheap US goods as they once did). They do this by artificially pegging the yuan to the dollar at a fixed rate. When the Fed prints more dollars, in order to prevent their currency from appreciating as it can now buy more dollars for the same price, the Chinese must expand their own balance sheet to print the money used to buy up the excess dollars in the system and maintain their target exchange rate to keep their exports flowing.
As such, China’s M2 is up 15.3% in April alone in part due to this phenomenon. This is an inflationary policy. There are more yuan than there used to be. So they too are worth less, although not as less as the even more in supply US dollar. And as you would expect, since they have real inflation, prices in China are on the rise. Their CPI, in fact, shows a 5.3% inflation rate. How come their CPI shows a much higher level than ours when our dollar is depreciating faster than their yuan? It all depends on how you measure it. The answer is that their CPI reflects real changes in commodities prices and ours discounts their impact in favor of finished goods. So to put it simply, where their CPI places a larger import on the price of raw materials and food ours places more emphasis products like the price of a cell phone. Considering the first Motorola cell phone retailed for $3,995 in 1983, the price has clearly gone down.
Regardless of CPI though, why would raw materials be impacted by the Fed’s relentless easing? Well, commodities are traded in US dollars which is the world’s reserve currency so a refiner in, say Japan, who has to purchase crude oil for distillation must first take its yen and buy dollars with it before going into the market to buy crude oil. The seller of crude knows that the yen bought its counterparty more dollars and thus will it charge more dollars for its oil, lest the next time he visits Tokyo and converts his less valuable dollars back into fewer yen he may be forced to stay in a Holiday Inn as opposed to a Ritz this visit.
To be sure, demand spurned by economic growth in the developing world is still the prime driver of raw materials price action. Complex systems like global markets are an expression of many factors. But if the supply/demand dynamic is what got dealers into the commodities market from the long-side, the Fed’s policies injected steroids into the rally and has now printed its way into a corner. It cannot initiate more easing as inflation is here. (As companies add more to their payrolls too, though good for the country as a whole, this will put ever more upward pressure on prices.) But should it start tightening by raising interest rates as I think is inevitable, making it more expensive for businesses to borrow, it could threaten the anemic recovery that is already showing signs of slowing if the Q1 numbers are any indication.
Meanwhile the average American is being squeezed ever more by rising prices and diminishing real value of their savings. The Fed and their enablers in the Federal City will have much to answer for in the years ahead. “What’s happening in Washington now is destroying the class of people who save an invest,” said investment guru Jim Rogers. “All the people who did the right thing are earning that much money right now. That’s not how the system is supposed to work.”
But that is how the overrated minds running the Fed and the Treasury, neither of whom has ever run a private business feel how the system should work. They seem utterly incapable of understanding that the past predicts the future…until it doesn’t. By the time we realize the world has changed and the old school approach is just that, it may be too late.