FixedIncomeRisk Forum

I don't know about you but I am having fun with this discussion.

I agree Buffet as a stock picker is smarter than any and all economists ever put on this earth. I won't argue that.

But he is an analyst of businesses and the general business environment and the econspeak "stagflation" is not really in his area. I don't ask the most brilliant native german speaker to define and characterize words in english and I don't ask the greatest stock picker of all time to characterize a term specific to a rare macroeconomic condition. Is he capable of a good opinion, yes. Should we take it into consideration, yes. But the term came out during a period of double-digit inflation and low growth. We are so spoiled by stable prices (thanks to economists like Volcker and Greenspan) that we forget what real stagflation is. That is my only point.

I am very glad you ask why food and energy don't matter. First, they do matter very much to consumers. Which is to say, all of us.

However, as a class of goods, food and energy represent highly inelastic necessities that consumers have an extremely difficult time substituting. Because of this, policymakers can do little to control for these prices in the short run.

one other reason for separating food and energy prices out from core inflation is that energy and food prices are subject to wider variation and can distort the overall underlying trend. Factors such as OPEC and weather lead to wild swings in these factors. Again, monetary policy can do nothing about the weather or the supply of oil. So factoring out food and energy gives a clearer picture of the underlying price pressures.

The problem of inflation is a big problem. It is a disease on the face of an economy. It represents a tax on Consumers but unlike an income tax nothing is flowing to the government and Nobody Is Gaining Any Benefit from the tax. even worse, inflation alters the behavior of consumers in a way that causes more inflation. Individuals, acting in their own self interest, actually make this situation worse by spending more rapidly and feeding inflation. When inflationary expectations became embedded in psychology of the American consumer, producers became more able to pass on higher import costs from factors such as energy back on to consumers. And consumers again continue to spend as fast as possible factor than prices can rise. The cycle just feeds off of itself.

Now here's the catch. In the short-run the amount of dollars able to be spent is fixed. If food energy prices are rising, that represents a cost to consumers that causes them to spend less on other goods. This is the case now and it is not an environment where producers can't raise prices on consumers very easily. What we see is that the economy will actually contract, and for the most part we are seeing that right now.

Whenever an economy is in recession it is extremely difficult for prices to rise. Demand shifts to the left, businesses layoff, and eventually inventories pile up and need to be sold off at lower prices.

During the 1970s we were able to see a period of high inflation and low growth. This was a special situation and there were some very important factors that were largely responsible. The first that was loose monetary policy when we needed to be tight. Most people blame political reasons on this and if you look into history books you'll find that President Nixon put a Fed chairman in and that would do exactly what he wanted to do -- speed up the economy and get him reelected. Secondly, we went off the gold standard which was a major realignment in our monetary system that allowed for prices to rise. Next, the baby boomers all came of age at about the same time and started buying things like houses and furniture, etc.. That is to say aggregate demand became more inelastic. Now throw an oil embargo and the Nixon administration's attempt at price controls. The 1970s were a true stagflation because the economic environment was a perfect storm for price is to start rising rapidly and for people to adjust the way they behave.

The economic environment right now is extremely challenging but it is eons away from being consistent with a stagflation environment. first of all, we are in a credit crunch. Businesses might want to raise capital right now and take their positive net present value projects to increase the value of their companies but they cannot because they cannot get funding.

Businesses are not expanding they are contracting. The labor market is not expanding it is contracting. And most importantly, incomes are not rising (you can ignore today's personal income and spending report as it is only indicative of economic stimulus checks and will not represent more than a blip on the radar screen). In real terms incomes are falling rapidly because of the energy inflation.

So in a nutshell this environment is not consistent with noncore inflation spilling over into core inflation and giving us a real stagflation.

I put together an econometric model with a student of mine last week based on fundamental factors. We cannot force-feed numbers into it that bring fair value of oil a barrel above $100. This situation cannot persist. Of course as Keynes said, "the market can stay irrational longer than you can stay solvent."

Gas belongs at about $2.50 right now and the idea of $7.00 gas is fantasy. We will have massive global instibility of epic proportion if this happens. I believe markets will at some point self resolve.

Finally, I appreciate your comments about houses being left out of the consumer price index but my guess is that it is because we don't consume houses. They represent an investment more than a consumer good.

Thanks for your stimulating comments. This is a great website!!

BusinessWeek
Bracing for Inflation
By John K. Castle

Growing evidence suggests American consumers, businesspeople, and political leaders should all be bracing for double-digit inflation, probably as early as 2009.

The relative price stability of the past 15 years is giving way to worsening inflation, despite the recent softening of oil prices. The Consumer Price Index for all items shows the inflation rate averaged 2.6% a year from 1992 through 2007 but has doubled since January, reaching an annual rate of 5.6% in July (BusinessWeek.com, 8/14/08). By next year, the monthly figure could hit double digits, and the inflation rate for 2009 overall could triple 2007's 2.85%.

I say this not only because I have looked at a broad range of statistics that point in this direction. I also run a private equity investment firm that owns companies in a number of industries -- including restaurants, the manufacture of gardening tools, oil and gas exploration services, and distribution of entertainment products such as books and videos -- that are already being forced to pass price increases on to the consumer.

The skyrocketing price of oil is obviously a central element in the accelerating price spiral. But a sea change in China's role (BusinessWeek, 6/19/08) is beginning to have a huge impact as well.

Increasing Commodities Pricing

Anyone who hasn't been living in a cave for the past year knows that oil prices have soared and pushed up the prices of gasoline, diesel fuel, and heating oil. Largely hidden from view, however, have been steep and continuing price increases across the whole spectrum of commodities.

Oil almost doubled in price, from $78.21 in July 2007 for a barrel of benchmark crude, to $145, where it peaked before dipping below $120. But from a longer perspective, oil sold for about $30 a barrel during 2003 and much of 2004. Thus it has actually quadrupled in five years. Coal, traditionally volatile, sold for about $30 a ton during 2003, peaked briefly at $63 in 2004, and went for $45.25 at the end of July 2007. A year later it hit $139.50 before slipping back a bit. It has tripled in 12 months.

Copper, another basic commodity, went from 82% a pound in July 2003 to $1.14 a year later, and to $3.72 by the end of last month. That's an increase of 350% over five years. The price of steel has climbed from under $240 a ton for hot-rolled steel coil throughout most of 2003 to $1,125 a ton last month, quadrupling in five years.

Grains have also soared in price (BusinessWeek.com, 7/18/08). U.S. corn prices jumped from $3.01 a bushel in July 2007 to $5.37 one year later. Wheat doubled from $3.05 a bushel in July 2006 to $6.02 last month. A Midwestern bakery owned by one of our portfolio companies turns out 13 million pies a year. The cost of ingredients of a standard pie jumped 100%, from $1.20 a year ago to $2.40 today.

In every sector, cost increases are so large and pervasive that producers who might once have tried to absorb or work around them are passing them on to customers as fast as they can. Dow Chemical (NYSE:DOW - News) recently announced successive price increases of 20% and 25%, plus freight surcharges, saying energy and feedstock costs had risen fourfold in five years.

China's Role

With commodity costs rising for so long, why are we feeling the impact so suddenly?

The answer is that China can no longer bail us out with low-cost manufacturing. For years, American manufacturers and retailers offset rising costs by sourcing more products from China, where they could be made cheaply. That kept prices down for American consumers and also restrained pressures on wages, abetting price stability. But now costs are rising quickly in China, too (BusinessWeek.com, 8/12/08).

The Chinese government, under pressure from the U.S., let its currency float upward by 21% against the dollar since depegging it in July 2005. It also increased its value-added tax by 11%, and removed rebates of the tax for most exporters. New labor laws, coupled with a tightening market for skilled workers, have pushed up labor costs by about 50% over the last three years. Meanwhile, Chinese producer prices rose by 10% in July, the fastest rate of increase since 1996. As a result, Chinese producers are demanding -- and getting -- price increases of 20% to 25% on goods they make and sell to U.S. customers.

Without the Chinese life preserver, prices at the big-box American retailers are likely to be soaring in the near future, and Chinese manufactured parts and components that go into U.S. cars and appliances are likely to experience similar gains.

Admitting We Have a Problem

Most Americans will have to tighten their belts and accept lower living standards unless this inflationary spiral can be stopped. There will be pain -- higher prices and a weaker economy, resulting in fewer jobs. Meanwhile, millions of Americans who are already feeling poorer because of falling home values and a soft economy will be further pinched by higher prices for heating oil, groceries, clothing, autos and appliances. Labor is unlikely to remain so quiescent, particularly as the expectation of inflation becomes clear.

The federal government and the Federal Reserve will be under pressure to take tough and politically painful steps to curb this inflation, including strengthening the dollar, raising interest rates, and tightening credit. But the Fed's ability to raise rates is constrained -- it needs to keep rates low to manage the mortgage-backed bond mess.

The first step in solving the problem is to recognize that we have one -- and it is serious. No American housewife has any doubts about that. Our policymakers shouldn't, either.

Yeah I saw that pile of fertilizer myself.

I used to work with those people but I don't know the author personally.

Notice, it was not written by Jim Cooper. Probably more of a journalist than an economist.

The subject is overplayed and it does not surprise me to see Businessweek playing the hot headline game. McGraw-Hill likes juicy headlines. I know that first hand. Too bad it is a disservice to the economy to be stoking inflation fears.

Now the Fed should be concerned about inflation and should not lower rates any more. But they can't raise them now without taking down the financial system. Once things clear up in the financial sector they can raise rates and squeeze out any core inflation that spills over from commodities.

Keep us informed if you see more of this and thanks for keeping this fun post alive.

JF

BTW, I do see he runs a private equity fund but his inflation evidence is anecdotal.

Hey Bond007,

Still worried about inflation

I didn't think so

I feel vindicated