Inflation, Silver and Gold, Oil, Meat and Grain and TVs

Traditionally, the Federal Reserve is always behind the curve when it comes to monetary policy. When inflationary pressures are building, the Fed fails to recognize it and doesn’t lift reserve requirements or raise short term rates. When the economy slows, the Fed has been guilty of not lowering rates or reserve requirements fast enough to cushion the fall.

But, after all the Fed isn’t a soothsayer. They are a group of intelligent individuals that discuss and look at indicators and decide. The Fed is human.  It also happens to be a centrally controlled organization, and open markets decide better than centrally controlled organizations.

There is a lot of consternation right now over inflation. The view on inflation is almost predictable depending on who you speak with. Speak with someone living on a fixed income, the inflation is real and difficult. Speak with someone who has an income that is growing at 3% a year, and inflation is almost imperceptible.

In the last thirteen years, we have had a lot of external shocks to the economic environment in the US.  They are, LTCM disaster, Y2K, the drop in tech stock valuation, 9/11, the subprime mortgage crisis, and the flash crash.  Each of these caused strenuous action at the Federal Reserve.  The Fed went above and beyond the call of duty each time to flood the money with easy credit.

These instances were easy calls for the Fed.  It was obvious there was a terrific shock.  Inflation is less obvious.  Like a secret agent it hides judiciously behind a screen and all of a sudden one day the world wakes up and it seems changed.

Today, if you take the same inflation measure we used in 1980, and combined it with U-6 unemployment, the Misery Index stands at 25.  Using the way they measure it today, it’s at 11.29, which is significantly higher than it was at any time under Clinton or Bush 2.  The reason the index isn’t significantly higher today is that under President Bill Clinton, they shifted the way they calculated the Consumer Price Index.  There is an argument that the misery index has been understated since the adjustment.  This also effects budget numbers by the way, making Clinton/Bush2 numbers look better than they really were when compared to Reagan/Bush1 numbers.

If we assume that the CPI would be higher under the old measurement, does it mean we have inflation?  If so, what are commodities telling us about inflation?

No doubt, you have read about commodity price inflation.  Look at a chart of Silver, Gold, Coffee, Cocoa, Sugar, Cotton, Corn, Wheat, Beef, Hogs, or Oil and you see a trend line pointing toward higher prices.  If you transpose those charts on a chart of dollar value, you will see a trend line toward a weaker dollar.  Hence, people jump to the easy conclusion that a weaker dollar is driving commodity prices higher.  The  easy answer must be, increase the value of the dollar and prices will drop.

But that analysis ignores all the market based facts on the ground.  Certainly the weak dollar policy employed by the Federal Reserve has increased the prices of commodities somewhat.  But what about the forces that really determine those market prices.  Here is a quickie analysis of each, and I apologize to specialists in each market if I have missed something.

Big Macro Trends:  Weaker dollar, globalization, rise of a worldwide middle class, Rise of terrorism, instability of the Middle East since the Gulf War started

Minor macro trends:  instability of the capitalist system in the free world caused by debt

Gold:  Ask yourself, when did the gold rally start?  It started on September 11, 2001.  Terrorism touched it off.  Since then the rise of the worldwide middle class has increased demand for gold.  Lots of unused gold assets are going from the closets of America and Europe into jewelry that’s being made for this middle class.

Silver:  This rally started later, but silver always rallies faster than gold.  It also falls harder.  Ask the Hunt’s.

Prior to the big rally, both gold and silver exploration and production were trending down.  When demand spiked, there was relatively little supply to keep up with demand.  Only thing for the price to do is go up.  Is this inflation?  A weak dollar?  Or true supply/demand pressure causing prices to rise?

Coffee, Cocoa, Sugar:  They are all traded at one exchange(ICE), and they are all grown in relatively the same latitude and longitude throughout the world. Guess what happened in the regions where they grow them.  Crappy weather.  They lost a lot of their crop.  That put a crimp on supply.  Add to that the destabilization of the Ivory Coast, where most of the cocoa is grown and you have another supply shock on your hands.  Again, is this true inflation because of a weak dollar or a function of the weather and government??

Cotton:  The southern US grows the world’s cotton.  So does India and Pakistan.  The entire crop in India and Pakistan was lost last year due to weather.  That left the US as the producer for the entire demand for fresh cotton.   Is the increased price of cotton caused by the decline in the dollar?  Or simply a supply shock?

Wheat and Corn:  There was a good crop of corn last year. Farmers this year are planting slightly more acreage.  However, 40% of the corn crop goes to ethanol production.  Since the US has progressively increased it’s production of ethanol over time via government fiat, the stock of grain in elevators has declined.  Currently, we are pulling grain stock out of elevators at the fastest rate in many, many years.  Five times normal rates I saw somewhere.  The rise of the middle class has changed food preferences, and more meat is being put in diets.  Animals need corn to grow.  This middle class rise puts upward pressure on prices.  Meanwhile, this year we have had continued rain (and tornadoes) in areas that need to be planted.  Only about 9% of the crop is in the ground.  Again, is this the dollar decline or really misplaced government policy?  If the government ended it’s ethanol policy, what would happen to the price of corn?

Hogs and Cattle (and Milk):  With the rise of the middle class, demand for meat protein in the form of chicken, hogs, and cattle has risen.  Recently, America inked trade deals with Korea and Columbia(pending) that will open up their markets to an increased supply of US meat.  Because prices were depressed in 2008 due to the financial crisis, producers thinned their herds and never regrew them.  Now, you are left with thin supplies and rising demand.  Plus, the cost of food and energy has increased, forcing producers to charge higher prices to break even. Again, is this simply a weak dollar or are there actual on the ground supply/demand issues driving prices.

Oil:  Ask yourself this question:  Since 2008 have we increased or decreased exploration for oil?  Obama has severely curtailed all exploration for oil within the US.  Add in the destabilization of the middle east governments where the lion’s share of oil is produced, the rise of the middle class in the BRICs which demand energy to survive and grow and you have an energy supply shock on your hands.  Is the price of oil only dependent on the value of the dollar?  Or is something else like really bad government policy regarding all energy driving it?

No doubt, over the past year, prices have gone up.  Anyone can read a market scoreboard.  But the driving factor behind this isn’t QE2.  Policies like QE2 have added fuel to the fire.  But the real driving factors are the underlying determinants of supply and demand, and some really poor misguided US government policies.

So, if price rises in commodity markets aren’t the be all end all of inflation, where is it?  Check the US Treasury market, specifically the shorter end of the yield curve.  When those rates jump, you know demand for money is jumping.  When demand for money jumps, we are going to have inflation like you remember from the 1970′s.  The other place to look is the stock market.  Uncontrollable inflation never rallies stock markets.  Of course, the Federal Reserve might see it coming and will pull the dry tinder out of the market before the wild fire starts.   Right?

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