Wednesday, May 16, 2007

Inflation or Simply A Case of Tight Supply?

Prices are rising. Oil hasn't come back down. Gasoline is at an all time high, and now it's starting to affect food.

California seems to be the first hit, with an annual rise of 5.7% of food prices. (Source.)

[Thanks to and the Energy Information Administration in DC for this reminder of the good old days back in 2002, with $1.35/gallon gas.]

The LA Times cites the Bureau of Labor Statistics's Patrick Jackman:

"We are going to see grocery store prices show one of the most rapid increases in the last 15 years or so," he said.

The article continues: "The real problem, according to food manufacturers and supermarket executives, is the run up in fuel prices and the cost of grain, which has soared as an ever-growing amount of corn is diverted to make ethanol to mix with gasoline.... Swanson said corn was the culprit for his estimate that food inflation will reach the 4% to 4.5% range this year, the highest since 1990. That's because corn is the building block for much of the American food supply. It is what dairy cows eat to make milk and hens consume to lay eggs. It fattens cattle, hogs and chickens before slaughter — depending on the animal it takes 2.5 pounds to 6 pounds of feed corn to produce a pound of meat. Corn syrup is the third-largest ingredient in Heinz ketchup and is the sweetener that goes into soda pop and hundreds of other food items. Corn also is the building block of the 7 billion gallons of ethanol made in the U.S. this year, a figure that is on its way to 14 billion gallons by 2011, according to estimates by Iowa State University.... As farmers discover just how golden corn has become, they are replanting fields formerly devoted to wheat, soy and other foods with corn, driving up the price of even more food commodities. Soy is up 28% to $7.41 a bushel from May 2006, DTN said."

Okay, so it's all tight oil's fault.... But wait a minute. What about the housing boom? Is that oil's fault?

"Oh no," some economists will reply, "the housing boom was created by revolutionary technological advances in the mortgage financing markets."

Hm. Don't know if I agree, but.... Okay, what about the booming prices for raw materials? All of them have skyrocketed.

"That's easy. That's because of the new global markets like China and India. Increased demand, that's all."

I say what about the fall in the exchange value of the dollar?

"The world thinks the US housing market will cause our economy to slow down, but the dollar will soon rise back up when they see things aren't so bad."

Maybe; maybe not. Then I say:

"What about today's huge corporate profits? Rampant corporate loans, and mergers and acquisitions? Why are they so high? And the financial sector? Why are they raking it in like never before? And if they're making so much money and there's so much global demand, why aren't corporations hiring like crazy, increasing salaries, and reinvesting in greater production? Could it be because they fear this is a monetary bubble and not an ordinary demand/supply scenario?"

Here, we get a silence. And I say to myself, "Because it is a monetary bubble."

Now, you the wage earner may say, "But when you come down to it, who cares? Prices are going up, and my salary isn't. What does it matter what is causing this to happen? I feel poorer already, and there's not a thing I can do about it."

True; for you it doesn't matter. But for the Federal Reserve, the fellows who are in charge of our monetary system and who are not supposed to create bubbles, this is a very crucial question. If the price increases are caused by normal economic factors like a limitation in the supply of oil, for example, then the Fed is not mishandling the money supply, inflation is under control, and the punctual price increases are a natural phenomenon that will take care of itself as energy producers respond to the increased profits by discovering and developing new avenues of energy production to their fullest potential. Then, once the new products are on the market, energy prices will decline, and so will those of products dependent upon energy and energy's raw materials.

Furthermore, because in that case the rise in prices would not be caused by a rise in general demand (which would be caused by a rise in your salary, and hence in your purchasing power, and hence in general demand for all kinds of things), but rather by a limitation of oil supply, the general price level would remain largely unaffected. Only those products involving petroleum raw materials and transportation would be touched. (As an aside, it would be interesting to do a study of which products' pricing does not contain some petroleum or transportation costs.)

However, if the Federal Reserve has been creating too much money supply, all prices will eventually rise and they will stay high on a permanent basis. This spells bad news for all of us, and our purchasing power in general will decline, our salaries will not keep pace until the very end of the process, those on a fixed income will be impoverished, savers will be punished, debtors will be rewarded, businesses will lose faith in their central bank, and GDP will underperform -- all conditions the Fed is supposed to prevent.

So if this rise in prices seems finally to be affecting more and more of the ordinary things we buy, how can we tell whether the driving dynamics are normal supply/demand or an inflationary bubble of the money supply?

I say this:

Maybe we can't; but if the Fed has recently been blowing hard and if the phenomenon swells like a bubble, if it rises like a bubble, and -- most importantly -- if it pops like a bubble: -- we'll know what it was, but only through hindsight.

Punchline PS: That's why the Fed and other central banks, if they don't want to take the blame for any damage done, should get out of the money supply management business.

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