The published inflation data are surprisingly unsophisticated in so far as they compare current prices with a snapshot a year earlier.

Just over a year ago, oil was every hedge fund manager’s favorite speculation. In summer 2008 a barrel got to well over $140, before falling sharply back.

That summer’s high oil price had the effect of canceling out the deflation which was occurring elsewhere in the economy, as the first phase of the credit crunch started to bite. It helped keep inflation up.

But by summer 2009, after hitting a trough of $30, the price was back down around $65 representing an annual fall in the oil price of over 50%. Now it was keeping the inflation figures down. Oil would continue to be below the price of 12 month previous throughout the period from January ’09 to September ’09.

Now – in the fall of 2009 – prices are more or less where they were a year ago, but 12 months ago they were falling fast, while now they are rising. So for the first time in over a year the effect of oil prices in the inflation figures, in October/November 2009, will be up again. And by January, even if prices don’t continue to rise from here, the low prices of winter 2008/9 will form the base. Oil will again be at twice the price it was a year earlier. This will have a marked impact on inflation data.

It’s not only the energy markets that threaten the “low inflation” data currently encouraging bondholders to continue buying government debt paying little more than 3.0% per year. There are well over two billion Chinese and Indians who used to make the unwelcome but necessary market adjustments on the demand side when world grain prices rose:

Some 30% of the world’s population went hungry.

Until the current decade, that was an important part of how world demand came into line with dips in world food production, before big price rises would cause Westerners to feel the sharp pain of a world food shortage. But this has now changed, and permanently.

The wealth and dollar reserves of the Asian countries are now large, and their people are not going to go hungry in future (and quite right, too). Instead they will be competing on world markets, and the price of grains will start to show the very sharp spikes associated with unreliable supply and a newly inelastic demand in critical commodities.

You may remember the food riots of early 2008, and how they seem to have disappeared. Well, that occurred after a small dip in world grain production in 2007. Fortunately, by its end, 2008 had turned into a bumper year for the global food harvest and a serious crisis was averted. That bumper harvest brought global food prices down again – but for how long?

Rice gives us a hint of the nature of price movements we should learn to expect. From a stable base it spiked viciously upwards (by 300% and more) as it sucked in speculative money during the 2008 panic. But when it fell back as panic subsided, it still remained twice the original base level. It is from here that the next upwards spike seems to be starting.

In a similar pattern sugar has already started to cool off a bit, but pepper is in the earlier stages. At the end of August ’09 it rose 17% in a week on news of a poor crop arising from adverse weather in South East Asia.

Unlike camcorders, food is not a discretionary purchase and under the harsh law of marginal utility – together with the new inelasticity of Asian demand – even modest food shortages will cause sharp price spikes, and maybe more riots, which indeed started to appear in Asia in September 2009, with tragic consequences.

When necessities are in short supply people behave in the opposite way to normal. Instead of reducing demand they tend to panic and stockpile food for safety, perversely increasing demand on those higher prices…

Regards,
Paul Tustain
BullionVault

October 13, 2009

The Price of Oil and the Inflation Time Bomb of Autumn was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Twenty-five years ago the Russians found themselves in a hole.

They had an official price for petrol (gasoline) of 1 ruble. But the cost of providing it, for example by buying it on world markets, was 8 rubles. Insofar as the state could supply any petrol to anyone at all, it was definitely going to be at a big loss. Yet they obstinately refused to accept that their price was wrong.

How we laughed at this dogmatic denial of the discipline of the market! We put it down to some sort of political imperative, but in fact it was much simpler than that.

Rather than lose money at a world-record rate, the Russian state responded by distributing official petrol in limited quantities, and only to favored clients, which in their society meant party members. The members used to fill up their Zil limousines with this cheap petrol, and effect a supply chain to retail via the simple device of draining their tanks into the jerry cans of local teenaged entrepreneurs – at 6 rubles per liter. That left the last 2 rubles to the entrepreneur, who sold it on the side of the street at 8, with hardly a murmur from official sources.

Party members were getting rich, after all, and the taxpayer was footing the bill.

Now substitute USA for Russia, and credit for petrol, and you have the essence of what is going on today. Can you get a mortgage in America or the UK at 2%, even if you pay a 50% deposit on your house? Certainly not. In America, only government mortgage agencies (Fannie and Freddie) and megabanks which are too big to fail have access to the 0.25% credit provided by the Fed. And once again, those megabanks are making very large sums, much of which gets distributed via bonus pools to those with an unremarkable talent for re-selling this cheap credit at market rates of 5.0% or more.

Political leaders regularly rail against greedy bankers, but the problem – all that cheap money – has for the last five years come directly from the false market in credit extended by ultra-low rate policies sourced in the Treasuries of the West.

Who’s at fault is academic. The issue now is that this artificially low interest rate environment can set off a hyperinflation chain reaction, just as it did in Russia once market forces prevailed. Not much is different from previous hyperinflation episodes, save that the melting of a glacially frozen stockpile of $50 trillion in government bonds performs the role traditionally played by the printing press.

In the end, those who have saved for their futures could form our own Babushka generation of pensioners. Paid out monthly, and in full, their pension will buy them a sandwich or two. The nominal value of sovereign debt will not decline, but the value of it will inflate away, taking with it the value of all those bonds.

We could end up needing to remove a couple of zeros from banknotes, because otherwise the coinage will be melted back into nickel and copper ingots as soon as it is issued, and then sold to the Chinese…

Regards,
Paul Tustain
BullionVault

October 12, 2009

Hyperinflation and Our Bankrupt Babushka Future was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.