Factors surrounding the raw inputs of economic production seem to be favoring inflation. Despite this, a quick background on the counter to inflation is necessary to yield a fair discussion.
Say what you will about Ben Bernanke, but he is one of the nation's best economists and experts on the inflation and deflation debate. I also hold Van Hoisington (a money manager in Texas) in high esteem regarding the inflation/deflation debate. His newsletters are powerful (if you're into this sort of reading). Both men are more worried about deflation than inflation. One (Bernanke) creates money, and other (Hoisington) puts his money where his mouth is.
Bernanke has a blank check to battle deflation, and has announced he just signed it. Hoisington's investment strategy, on the other hand, only invests in either long-term Treasury bonds or T-Bills - a very black and white strategy regarding inflation and interest-rates. According to his recent remarks, rates are headed even lower and deflation is clearly the problem. So, Hoisington owns long-term Treasury Bonds. These men are not a team, but share the same view that deflation is the dominant threat at hand (not actually occuring, but threatening). To bet against them is bold.
Perhaps what is just as bold, is to ignore the other side of the debate. I won't try to frame this debate, but perhaps describe some of the kindling that is being tossed into the fire. For one, critics of the Fed's recent strategy to quantitatively ease economic conditions (by purchasing up to $600 billion in Treasury bonds) fret that this will stoke inflation. Here, the main worry is that money supply is growing, and eventually this strategy might wind up causing inflation as the speed of money circulation (velocity) increases - perhaps in the case of a strenghening economy. The counter to this concern is that the Fed could withdraw stimulus once the economy strengthens. Despite this, another related concern regarding inflation relates to the factors of economic production - specifically, the raw inputs of economic production.
The 1970s ushered in a period where fiat currency ruled as Nixon terminated the Bretton Woods arrangement. Not only did the global supply of currency (along with plenty of money velocity) lead to inflation, but so did the restriction of basic economic inputs - notably oil (see 1973 Oil Crisis). As supplies were limited, demand remained elevated - leading to rising prices. Essentially, restricting oil demonstrated that this basic economic input could cause price spikes not only in oil, but in almost any good or service that depended on it.
Today, we are witnessing similar trends in the restrictions of basic economic inputs. I highlight three examples:
1) Rare earth metals. China mines 97% of rare earth metals. Much of the modern economy depends on these metals as they are used in a whole host of products including catalytic converters in cars, TV and computer monitors, and pharmaceuticals. Recently, China has been testing the waters regarding limiting its supply to non-Chinese businesses who rely on these materials.
2) Oil. The nationalization of oil has been a longer-term trend, but headlines regarding governmental takeovers of private oil company assets are seen with some regularity. Today "only 7% of the world's estimated oil and gas reserves are in countries that allow private international companies free rein." Further, consider that companies like Exxon-Mobil are "not making nearly the investment in finding new oil that it did in 1981."
3) Phosphate.What? Yes, phosphate is used in everything from rechargeable batteries, to corn syrup, to fertilizer. Morocco's King Mohammed VI, owns more than half the world's phosphate reserves. According to a recent Business Week article, "Mohammed's strategy, by most accounts, is to drive the commodity's price higher yet—which means the cost of making everything from corn syrup to iPads will be going up as well."
So while the unemployment, idle capacity, the speed of money seem to be keeping a lid on prices for now, the tectonic plates of inflation seem to be putting upward pressure on this lid. In my view, current factors seems to be favoring low inflation, but longer-term trends related to raw materials and money supply will eventually kick in. A lot of analysis is dedicated to a scenario like that of Japan over the past two decades - one of low growth and low inflation. However, another scenario, which I don't hear about much relates to the U.S. in the 1940s. In this environment, the Fed determined to keep interest rates low (via Treasury purchases or debt monetization - basically quantitative easing). Over the 1940s 10-year Treasury bonds hovered in the 2.5% range. Inflation over this period, however, averaged 5.4% as a result of the post war boom - and perhaps quantitative easing.
Bernanke is a great student of economic history, and Paul Volcker demonstrated that inflation can be stopped in its tracks. Regardless, almost anything can happen, and the tectonic plates of inflation are clearly shifting.
Jack Brown, CFA