A danger of inflation: The misallocation of resources on the way to sustained price increases (an explanation of the mission of Inflation Watch)Posted: May 31, 2011
In January of this year, Professor Russ Roberts of George Mason University invited fellow economics professor Don Boudreaux to address “Monetary Misunderstandings” on the weekly podcast “EconTalk.” From the synopsis:
“Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.”
I was most interested in the discussion about the definition of inflation because I understand the importance of maintaining technical and economic clarity on this topic for “Inflation Watch.”
Boudreaux first deferred to Milton Friedman’s famous empirical proclamation “inflation is always and everywhere a monetary phenomenon” and lamented that the economics profession no longer defines inflation as an increase in the money supply. Now, inflation represents a sustained increase in the average price level in the economy. Inflation is not simply any increase in price; Boudreaux complained that this definition is a common misconception of non-economists. However, he acknowledged that he personally thinks inflation’s largest threat is the process by which price increases become sustained. This process features uneven injections of money into the economy, causing specific and identifiable distortions in the economy that lead to a misallocation of resources. (Roberts somewhat disagreed as he expressed much greater fear of hyperinflation).
Bill Fleckenstein first taught me this notion that increases in the money supply distort specific areas of the economy. Such distortions can morph into bubbles, inflation’s ultimate misallocation of resource (capital). Bubbles can occur without ever tipping the economy into an inflationary cycle via official government statistics. So, it is very easy, for example, for the Federal Reserve to do nothing about soaring prices in an important sector of the economy and instead simply plan for the ultimate clean-up of the bubble’s aftermath. In recent history, the disastrous wakes of bubbles have forced the Federal Reserve to resort to easy money policies that invariably help fuel the next bubble. (Fleckenstein famously reviews this process and a lot more in “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.”)
Through Inflation Watch, I identify news of price increases not because any one price hike defines inflation; as noted above, this approach is technically incorrect. Instead, these stories offer clues that potentially can uncover the misallocations of capital that flag inflationary forces may be developing. I am trying to piece together a mosaic of economic activity that may provide early indicators of inflation well ahead of the moment that government statistics show it or the moment the Federal Reserve officially announces an inflationary process is underway.
The general context is important. We are currently experiencing an extended period of easy money policies in most of the globe’s developed economies. Presumably, this money must go “somewhere” at some point in time. Financial markets are the perfect conduit for easy money; investors and speculators alike will flock to those parts of the economy that promise some protection against the devaluation of currency and/or profits from inflationary pressures. (Boudreax and Roberts never directly addressed the enabling influence of financial markets for transmitting inflationary pressures). I have argued in previous posts that the most favorable hosts for easy money are where demand is particularly robust and supply may be constrained or stressed. Today, commodities represent a perfect storm for global easy money policies. So, many of the recent stories in Inflation Watch have focused on commodities and industries dependent on consuming commodities.
The Federal Reserve’s current bias toward inflation shows because the Fed has demonstrated relatively quick action to thwart the perceived threat of deflation. The specter of the Great Depression always looms large. Recall that after the dot-com bubble burst, Greenspan cited the threat of deflation as a prime reason for aggressively loosening monetary policy. The crash of the housing bubble of course generated an even more aggressive policy of monetary easing given housing’s importance to the overall economy and consumer spending. The Federal Reserve’s recent success in averting deflation certainly adds confidence in applying easy money policies, much to the likely chagrin of devout deflationists. Meanwhile, the Federal Reserve has also made it clear that it will not act against inflation until price increases (or the expectation of price increases) reach sustained levels over time.
For example, last week, Bloomberg quoted Federal Reserve Bank of Chicago President Charles Evans in “Fed’s Evans Says ‘Slow Progress’ in Economy Justifies Maintaining Stimulus“:
“Inflation is a continuing increase in the price level over time: A one-off increase in the price level is not inflation…Price increases have to be sustained.”
I duly noted that at no time does someone from the Federal Reserve insist that deflation is a continuing decrease in the price level over time!
Evans goes on to express his comfort with the current levels of inflation by citing empirical research showing no correlation between higher oil prices and inflation. Even a casual examination of the current record of price increases demonstrates that oil’s price rise is just one small part of the general increase in prices percolating in the economy, especially where demand is strong and supply is compromised. Regardless, the conclusion of this research is intuitive given the numerous supply-related fluctuations in oil that have occurred with and without Fed monetary action. As we saw above, it is not likely that the increase in prices in any one part of the economy will produce the sustained increase in price levels required to signal inflation’s arrival. Without an increase in the money supply, increases in oil prices steal money from some other products in the consumer’s basket of goods. The net impact on official inflation statistics may be close to zero and “core” inflation, subtracting energy and food, could even decrease! But if increases in the money supply happen to coincide with a strengthening oil market, I contend we better look out.
The bias of the Federal Reserve toward inflation is also rooted in the concept that “a little inflation” is good for the economy because it encourages spending. Specifically, inflation encourages consumers to buy today to avoid paying higher costs tomorrow. In a deflationary environment, consumers just wait and wait and wait. Boudreaux and Roberts sharply criticize this theory and cite examples demonstrating the fallacy of such thinking. For example, with even a little inflation, why don’t sellers just wait until tomorrow to sell since they can make higher profits? Why do consumers buy computers and many other electronic goods knowing full well that prices will be lower tomorrow (not to mention these goods will be of higher quality)? Why was America’s post-Civil War economy so strong for almost 30 years despite persistent deflation? Clearly, buyers and sellers are motivated not just by relative prices, but also the relative value (or utility) gained from consumption and/or alternative investments.
I have covered the core concepts reviewed by Boudreaux and Roberts related to the philosophy and approach of “Inflation Watch.” If you want more detail, I highly recommend listening to the podcast, reviewing the transcript, and/or perusing some of the references provided by EconTalk. Hopefully, you have also gained a better understanding of Inflation Watch’s mission: “Watching for inflation here, there and everywhere.”
Reader Jay writes:
Do you think TIPS are a good inflation hedge? Some say the Fed will raise interest rates well before significant inflation is captured in the official CPI. Theoretically does the market go up during inflation? What are some other good hedges other than gold and gold stocks?
Hm, Inflation Watch isn’t an investment blog. I’d like to take a stab at Jay’s questions, but please keep in mind that nothing on this blog should be construed of as investment advice. (Do your own research!)
1. Treasury inflation-protected securities (TIPS) were a steal in late 2008, when everyone was worried about deflation. Less so now, because the market has priced in higher inflation expectations. Nonetheless, in my opinion, TIPS are an excellent inflation hedge if held over a long period of time. I don’t personally own TIPS but I would seriously consider buying the iShares Barclays TIPS Bond Fund as a long-term holding if prices pull back significantly from current levels.
2. The short answer is that the stock market can go either up or down in times of inflation. Certainly there are many companies (for example, those that have pricing power) that can prosper in times of inflation. But for the market as a whole, generally stable prices are best. So a complete answer to Jay’s question is that it depends on a number of factors, including how much inflation there is, how the Fed responds to it, and how predictable the inflation rate is. For example, low, predictable inflation that is carefully kept in check by the Fed is a lot better for the stock market than high, unpredictable inflation that is ignored by the Fed.
3. Other good inflation hedges, aside from gold and TIPS, include real estate (or real estate investment trusts), land, commodities, and any asset denominated in a foreign currency.
At times during the past 18 months, I have owned the ProShares UltraShort 20+ Year Treasury Bond Fund (TBT). I have also owned long-term puts on the iShares Lehman 20+ Year Treasury Bond Fund (TLT). Although both of these holdings performed extremely well, I do not recommend them now and I certainly do not recommend them for long-term investors.
Do you have a question for Inflation Watch? Send us an e-mail at inflationwatchblog -at- gmail -dot- com.
Mark Congloff at the Wall Street Journal says that until unemployment starts to drop, inflation “remains a distant threat.”
If that’s the case, then why has gold performed so well the past year? Why have long treasury bonds performed so poorly?
Add New Zealand to the list of countries confronting higher-than-expected infation. From Bloomberg News:
New Zealand inflation accelerated faster than economists forecast in the third quarter, adding to signs that central bank Governor Alan Bollard may have to raise interest rates earlier than he predicted last month. Consumer prices rose 1.3 percent from the second quarter, Statistics New Zealand said in Wellington today. Inflation was more than the 0.8 percent median estimate in a Bloomberg survey of 11 economists.
- Inflation picking up steam in Argentina
- Nomura: Inflation to surge in India
- “Inflation [in India] is poised to shoot through the roof.”
Last week, I noticed media headlines screaming the horrible news that “Crude steel output in 2009 to hit lowest level in 40 years.” As I searched for the direct source of this quote from Japan’s Ministry of Economy, Trade, and Industry (METI), I stumbled upon its “Preliminary Report on Iron and Steel, Non-ferrous metal, and Fabricated metals Products Industry.” From my standpoint, the monthly data shown below clearly demonstrates that steel production likely bottomed in March/April and is in the middle of a rapid recovery (charts copied below). So, yes, when the year is all said and done, the aggregate numbers will look terrible – as will most aggregate economic data – but the current trend seems to suggest that some kind of recovery is in place.
The price of steel rose all summer and finally stumbled again in September. On Sept 4, Reuters reported: “Chinese spot steel prices fell 2.6 percent in their third consecutive weekly fall, led by construction steel, as major mills continued to cut prices on weakened demand following a steep price run-up in recent months. After a months-long rally to a 10-month high in early August, China’s steel prices turned lower and prices of benchmark hot-rolled coil fell.” Two weeks later, the Wall Street Journal had dour news about the U.S. steel industry: “Steel Prices Drop, Reversing Course in Sign Mills Ramped Up Too Quickly.” Specifically, “Hot-rolled steel, a benchmark grade that typically is processed into cars, building structures or appliances, cost about $600 to $620 a metric ton in August. Now it can be had for about $550-$570 a ton, a drop of about 8%.” However, the article also quotes the president of the American Institute for International Steel claiming that “Steelmakers overreacted in swiftly closing steel mills last year and in early 2009…they took out too much production.” Indeed, U.S. steelmakers increased production each of the previous 11 weeks.
Overall, it seems that the recent price decline remains a hiccup amidst an upward trajectory from an ugly bottom. The evidence from this summer’s bout of price increases suggest that demand for steel is firming and customers are absorbing a myriad of price increases (including surcharges). The list below is a sample of the wide array of price increases in steel-related products from this past summer. Given the stall noted for September, October’s round of earnings announcements will be critical in determining whether the upward momentum still has legs. Until then, it seems to me that the decline in steel prices and production has been arrested for now and further increases in demand will drive additional inflationary momentum in steel.
- June 1: AK Steel (AKS) announces “…it will increase spot market prices for its carbon steel products by $20 per ton effective with new orders scheduled for delivery on July 1, 2009 and later.”
- June 18: AKS announced “…it will increase spot market prices for all carbon and stainless flat rolled steel products.” The various price increases appear comprehensive in scope and type.
- July 09: AKS announced “…it will increase spot market prices for its carbon steel products, effective with all new orders for August and September shipments. Base prices for hot rolled products will increase by $40 per ton. Base prices for cold rolled and coated products will increase by $50 per ton.”
- July 23: Nuecor (NUE) announced during its earnings conference call that it would implement price increases for the first time in nine months: “With stronger demand, we are implementing price increases in each of our products for the first time in about nine months. These stronger business conditions have continued into July. Across all of our steel mill products, we believe the catalyst for this upturn in demand is the result of service centers completing their inventory, destocking cycle.” (Seeking Alpha transcripts)
- July 23: Synalloy Corporation (SYNL) announced during its earnings conference call that “…surcharges have increased every month since May 2009, and our steel suppliers implemented a 6% price increase on May 1, 2009 and a second 6% price increase on July 1, 2009, which the industry thinks will be accepted in the marketplace.”
- July 28: U.S. Steel (X) responded to an increase in demand by increasing prices: “We have began to bring up idle facilities inline with customer demand, and we have implemented price increases in our Flat-rolled and USSE segments in the third quarter.” (Seeking Alpha transcripts).
- Jul 29: Arcelor Mittal (MT) announced during its earnings conference call that it expects increases in base prices in Europe. (Briefing.com)
- July 30: AKS announced “…it will increase spot market prices for its carbon steel products by $40 per ton, effective with all new orders for September and October shipment.”
- Aug 04: AKS announced “…it will increase base prices for all 200, 300 and 400 series flat rolled stainless steel products by 6% to 9%, depending upon the grade and product form, effective with shipments on August 30, 2009.”
- Aug 06: Gerbau Ameristeel claims during its earnings conference call that “During the quarter, we saw a stabilization of volumes as destocking by our customers appears to be slowing, as well as a firming of steel prices across all steel products.”
- Sept 01: AKS announced “…it will increase spot market prices for its carbon steel products, effective with all new orders. Base prices for hot rolled products will increase by $40 per ton. Base prices for cold rolled products will increase by $50 per ton. And, base prices for coated products will increase by $60 per ton.”
Be careful out there!
Full disclosure: long X calls, STLD