Central bank debate: Is it inflation or deflation?
on March 3, 2008 in China, Currencies, India, Inflation, Oil, Russia 5 Comments
Here’s how the inflation can persist indefinitely:
- In addition to the India/China type story for resource demand, this time around nominal demand for commodities is also coming from our own pension funds who are shifting more of their financial assets to passive commodity strategies.
Pension funds contributions have traditionally been invested primarily in financial assets, making them ‘unspent income’ and therefore ‘demand leakages.’ Other demand leakages include IRAs (individual retirement accounts), corporate reserve funds, and other income that goes ‘unspent’ on goods and services.
Supporting these demand leakages are all kinds of institutional structure, but primarily tax incentives designed to increase ‘savings’.
These come about due to the ‘innocent fraud’ that savings is necessary for investment, a throwback to the gold standard days of loanable funds and the like.
A total of perhaps $20 trillion of this ‘unspent income’ has accumulated in the various US retirement funds and reserves of all sorts.
This has ‘made room’ for the government deficit spending we’ve done to not be particularly inflationary. In general terms, the goods and services that would have gone unsold each year due to our unspent income have instead been purchased by government deficit spending.
But now that is changing, as a portion of that $20 trillion is being directed towards passive commodity strategies. While the nature of these allocations varies, a substantial portion is adding back the aggregate demand that would have otherwise stayed on the sidelines.
That means a lot less government deficit spending might be needed to sustain high levels of demand than history indicates.
And, of course, the allocations directly support commodity prices.
- We are faced with the same monopoly supplier/swing producer of crude oil as in the 1970’s.
Back then the oil producers simply accumulated $ financial assets and were the source of a massive demand leakage that caused widespread recession in much of the world. And didn’t end until there was a supply response large enough to end the monopoly pricing power.
But it did persist long enough for the ‘relative value story’ of rising crude prices to ‘turn into an inflation story’ as costs were passed through the various channels.
And a general inflation combined with the supply response served to return the real terms of trade/real price of crude pretty much back to where they had been in the early 1970’s.
- This time around rather than ‘hoard’ excess oil revenues the producers seem to be spending the funds, as evidence by both the trillions being spent on public infrastructure as well as the A380’s being built for private use, and the boom in US exports- 13% increase last month.
This results in increased exports from both the US and the Eurozone to the oil producing regions (including Texas) that supports US and Eurozone GDP/aggregate demand.
At the macro level, it’s the reduced desire to accumulate $US financial assets that is manifested by increasing US exports.
(This reduced desire comes from perceptions of monetary policy toward inflation, pension fund allocations away from $US financial assets, Paulson calling CBs who buy $US currency manipulators and outlaws, and ideological confrontation that keeps some oil producers from accumulating $US, etc. This all has weakened the $ to levels where it makes sense to buy US goods and services – the only way foreigners can reduce accumulations of $US is to spend them on US goods and services.)
The channels are as follows:
- The price of crude is hiked continuously and the revenues are spent on imports of goods and services.
- This is further supported by an international desire to reduce accumulation of $US financial assets that lowers the $ to the point where accumulated $ are then spent on US goods and services.
For the US this means the export channel is a source of inflation. Hence, the rapid rise in both exports and export prices along with a $ low enough for US goods and services (and real assets) to represent good value to to foreigners.
- This is not a pretty sight for the US. (Exports are a real cost to the US standard of living, imports a real benefit.)
Real terms of trade are continually under negative pressure.
The oil producers will always outbid domestic workers for their output as a point of logic.
Real wages fall as consumers can find jobs but can’t earn enough to buy their own output which gets exported.
Foreigners are also outbidding domestics for domestic assets including real estate and equity investments.
- The US lost a lot off aggregate demand when potential buyers with subprime credit no longer qualified for mortgages.
Exports picked up the slack and GDP has muddled through.
The Fed and Treasury have moved in an attempt to restore domestic demand. Interest rate cuts aren’t effective but the fiscal package will add to aggregate demand beginning in May.
US export revenues will increasingly find their way to domestic aggregate demand, and housing will begin to add to GDP rather than subtract from it.
Credit channels will adjust (bank lending gaining market share, municipalities returning to uninsured bond issuance, sellers ‘holding paper,’ etc.) and domestic income will continue to be leveraged though to a lesser degree than with the fraudulent subprime lending.
Pension funds will continue to support demand with their allocations to passive commodity strategies and also directly support prices of commodities.
- Don’t know how the Fed responds – my guess is rate cuts turn to rate hikes as inflation rises, even with weak GDP.
- We may be in the first inning of this inflation story.
Could be a strategy by the Saudis/Russians to permanently disable the west’s monetary system, shift real terms of trade, and shift world power.