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INFLATION WILL COME MORE AND MORE INTO PUBLIC AWARENESS OVER THE NEXT SEVERAL YEARS

There are many indicators of inflation in the world that we watch to forecast oncoming inflation. Currently, the great majority of these tell us that the inflation we have seen so far…is just getting started.

In our newsletters at Guild Investment Management we have been talking about inflation and its expected arrival for almost two years. We have pointed out the reasons for inflation, and discussed them in a general way. I would like to go into each one individually in a short memo that we will send to clients and to the CIGA’s in the next few weeks. The public media has picked up on the theme of inflation in the last few months, and they have been haranguing the public about higher food and energy prices. As a result, many people believe that once the rate of the rise in food and energy prices slows, the rate of increase in inflation will recede.

IT IS NOT THE CASE THAT FOOD AND ENERGY ARE THE SOLE OR MOST IMPORTANT DRIVERS OF INFLATION TODAY. Inflation is a function of many variables and there are about 10 of them that we will discuss in coming memos.

INFLATION DRIVER #1: THE LONG GLOBAL ECONOMIC EXPANSION CREATES INFLATIONARY TENDENCIES IN AN ECONOMY

The economic expansion that began in 2003 was still going strong as the end of 2007 approached. The current banking crisis in the developed world has caused it to slow. However, the economic growth rate did not slow in the developing world, and the tendencies leading to inflation remain strong globally.

Some governments are still trying to tell their constituents that the U.S. and European economies are growing, but at a much slower rate. On the other hand, important economists in both regions agree that the U.S. and Europe are at least in a growth recession…if not an outright recession.

In either case a slight recession or slow growth the current economic climate has been strong in the developed world for 5 years and in the developing world [which is more important] it has been going on for closer to 10 years. China, India, Brazil, Russia the mid eastern oil producers and many other countries continue to grow at a very rapid rate as I write this memo

APART FROM THE DEVELOPED WORLD, EVERYONE IS STILL GROWING…AND SOME BIG COUNTRIES ARE GROWING VERY FAST.

PROLONGED AND INCREASING ECONOMIC GROWTH STIMULATES INFLATIONARY EVENTS IN THE ECONOMY.

Perhaps it is shortages of raw material, skilled labor…or, maybe it is the need for speedy delivery to a customer. Maybe new customers and new markets are all putting pressure on suppliers to achieve rapid execution in getting the deliveries out on time and with good quality…at the expense of price.

IN BOOM TIMES, PRICE INCREASES ARE EASY TO PASS THROUGH. THIS LEADS TO PROFIT MARGIN EXPANSION.

Of course, price increases lead to inflation. In this way, a long economic expansion (such as the one that the world is currently experiencing) will lead to higher prices. When customers’ profit margins are strong, eventually the customers allow their suppliers to raise prices and enjoy higher margins as well. Higher margins come as result of higher prices.

A long economic expansion breeds higher prices, and is the first of 10 influences on inflation. Stay tuned for more about what drives inflation.

INFLATION DRIVER #2: GOVERNMENTS ARE QUICK TO ADDRESS THE DOWNSIDE RISKS TO THE BANKS AND THE FINANCIAL SYSTEM. THIS IS DUE TO A NUMBER OF FACTORS, BUT PRIMARILY IT IS DUE TO A CHANGE IN THE PSYCHOLOGY OF GOVERNMENTS REGARDING BANK SOLVENCY AND ECONOMIC GROWTH.

SIMULTANEOUSLY, THEY HAVE BECOME SLOWER TO MOVE TO STOP INFLATION FROM BECOMING EMBEDDED IN THE SYSTEM.

Now that they recognize inflation is becoming a problem, they have begun to address it…but in words only. Thus far, U.S. Federal Reserve has spoken about the possibility of higher interest rates, but they have done nothing. U.S. interest rates are lower now than when the inflation rate was almost 2% per annum lower. Higher inflation should mean higher interest rates, but thus far it hasn’t. The ECB has also recognized inflation is higher than their targets, but thus far has only spoken of instituting higher rates.

Government officials have become afraid to not limit the downside risks to their economy due to social and political pressure. The days of the hard nosed, tough central bankers in the U.S. and many countries has ended. Inflation, which was a specter that stalked the world in the 1970’s, has been pushed to the back of the institutional memory of politicians and bureaucrats who run the day to day activities of government. The days when inflation, and wages adjusted to inflation, caused havoc in the 1970’s are remembered by some of the older financial types, but not by government as a whole. As a result, people in the developed and developing world are slow to act to restrain inflation. This slowness to restrain it causes inflationary psychology to become imbedded in the public mind. As we will discuss in future memos this can be a serious problem.

MORAL HAZARD

Another major issue is that the U.S. and Europe have become more social democratic or socialist in the governmental policies in the last thirty years. Thus, an institutional bias by government toward protection of the public at all costs has risen. In other words, the institutional bias that existed in the U.S. in the 1970’s that said that the individual was at least partly responsible for their personal financial future has eroded. In the 1970’s, I do not recall anyone thinking that it would ever be OK for the government to take over a bank like Britain did when it bailed out Northern Rock; publicly stating that it was making good all deposits…even those well in excess of the insured maximum. In fact, many crises of the seventies were correlated to a major bank failure. At those times, people who had deposits in excess of insured amounts were just out of luck.

INFLATION DRIVER #3: GOVERNMENT SUBSIDIES

Today, food, energy and other consumables are subsidized by the governments of countries where about 4 billion of the world’s people live. China and India are rife with subsidies for food, energy and other goods…as are many dozens of other countries globally. These subsidies are a mistake and will create inflation when they are lifted.

Governments subsidize the price of food, energy and other consumables for political purposes…it is a good way to curry favor with voters. These have been a favorite with centrally planned economies for decades. Their history goes back much further to some of the world’s ancient civilizations. There has in my opinion, never been a track record of long term success for these types of programs. Politicians are attracted to them because they are popular with consumers. The programs cut costs for consumers, but someone has to absorb the loss on the subsidy. Usually, it is the taxpayers or the owners of companies who are asked to lose money on the goods that they sell to consumers at below cost.

For example, if world prices of gasoline are $4.50 per gallon and you can buy gasoline for $2.00 per gallon in Vietnam, why would you not purchase gasoline for $2.00 and resell it in another locale (a neighboring country) at something closer to the world market price of $4.50? The answer is that many people will, and this leads to over-consumption, black markets, shortages, smuggling and many other socially unattractive side effects. Higher prices ration demand and lead to lower consumption artificially low prices incentivize consumption. Eventually, shortages and rationing follow…and the government is then forced to move the subsidized price closer to world prices. By now world prices will be much higher than the subsidized price thus setting off a wave of price inflation.

Subsidies are a shortsighted strategy to “improve” the standard of living for their constituents, but they encourage waste and inefficiency…and eventually painful adjustment when they are lifted. Subsidies often lead to inflation and redistribute wealth from the government or the rich to the poor. Once the cost becomes too expensive for the government to bear, or when the private companies who have been forced to sell at below market prices go broke, prices are forced to rise rapidly. The price rise hurts those who have not learned to conserve…often more than they would have been hurt if subsidies had never been introduced.

INFLATION DRIVER #4: PRICE CONTROLS

Along with subsidies (which we discussed yesterday) and tariffs (which will be covered in our next memo), price controls are a common but destructive economic tool. They are politically motivated and substitute the intelligence of bureaucrats for the intelligence of the marketplace by telling companies and individuals the prices they can charge for goods and services. Often, the prices are slow to reflect cost increases, and companies and individuals can experience losses and dislocations in profits if the price controllers are not proactive, effective and accurate.

The way they hurt an economy depends upon many variables, like whether they are all-inclusive, whether they are instituted in concert with wage controls, how much free trade the world and the country enjoys and so forth.

Like subsidies and tariffs price controls cause a misallocation of resources, non-economic behaviors on the part of the government, and antisocial behavior on the part of the public.

Price controls often go hand in hand with: shortages, conniving behavior by businesses and consumers, declines in production, declines in quality, and many other problems. A common problem in price controlled economies is that capital will not be invested to grow businesses because a fair return on capital can not be obtained. So, the manufacturing and employment capacity of the economy will usually fall. This may have the unintended consequence of slowing economic activity and increasing unemployment.

Price controls cause the creation and growth of bureaucracies to administer the controls. These bureaucracies often develop lives of their own and become difficult to remove, causing the controls to last years longer than they should…which further diminishes economic growth.

The biggest problem is that price controls cause a build-up of unfilled price increases and diminished production (people don’t produce for a loss if they can help it). When shortages and economic dislocations caused by the controls finally become politically unpalatable, and politicians remove the controls…INFLATION ACCELERATES.

These make up reason #4 why inflation will be here for a while, and why it is not being driven solely by food and energy price rises.

INFLATION DRIVER #5: TARIFFS

Tariff, according to Webster’s Dictionary, is defined as “a list or system of duties imposed by a government on imported or exported goods”.

The reasons countries put duties on imported goods is because they can not produce them as well, or as cheaply. Even after the cost of transporting some goods to the country importing them, the price is still lower, or the quality higher, than domestically produced goods. A second reason for tariffs is to limit the options of the consumers in an importing nation, and tell the consumers how to spend their money…because politicians and bureaucrats believe that they know better than the consumers how the consumer should act.

In effect, import tariffs exist because sometimes the governments believe they know more than you. However, more often they are imposed because of politicians’ and their constituents’ special interests (often involving donations to the politicians’ reelection campaigns) and hinge upon keeping competition out…thus, supporting inefficient industries.

Export tariffs or duties on exported goods exist to keep prices down…often once a government created inflation cycle has begun. The effect of export tariffs is to disallow manufacturers from selling abroad at higher prices, and making suppliers keep their goods at home where the public can enjoy a lower price…at the manufacturers’ expense.

It doesn’t take much vision to see the economic dislocations and inefficiencies created by tariffs. If an exporter is faced with a tariff he will produce less and invest less to expand production, thus creating longer term supply shortages and higher prices. If an importer faces import tariffs, he will utilize lower quality or higher priced domestically manufactured goods, and thus sell to consumers at a higher price. Efficiency and value to the consumer are sacrificed. This also pushes inflation higher.

Those that argue for tariffs on the basis of job retention or holding domestic prices down are looking at short run, politically expedient effects and ignoring the long run inflationary effects.

INFLATION DRIVER #6: GLOBAL COMMODITY DEMAND IS GROWING FASTER THAN NEW SUPPLIES CAN BE ADDED

As many of you know, economists can not agree on the causes for inflation, so our series of ten inflation drivers covers several economic viewpoints about inflation.

Infrastructure Demands Raw Materials

Commodity demand is rising faster than supply. The demand for commodities in the developing world, to fuel infrastructure and manufacturing growth, is a much repeated theme of ours. This is a simple macroeconomic observation. Developing countries like China, India, and many others are consuming raw materials more rapidly than the supply of such materials is expanding. When China wants to spend several trillion dollars to improve their railroads, roads, electrical grid, water, and other infrastructure, they require massive amounts of raw materials like coal, iron ore, copper, aluminum, nickel, zinc, oil, natural gas, cement, and many other materials. Many of these materials must be imported, and when China or any other country goes into the global markets to purchase these materials, world supplies tighten. It takes many years to build a new coal mine, iron ore mine, and nickel mine, etc.

Higher Standard of Living Demands More Agriculture Commodities

Further, when China, Russia, India and other countries’ economies grow, and they enjoy a rise in the price of the commodities that they export, their standard of living rises. When people enjoy a rising standard of living, they tend to upgrade their diet and eat more expensive protein-rich meat. If more meat is part of the diet program, the prices of grains used to feed animals will rise. Growing meat protein is an inefficient use of grains. Beef and mutton take about 8 pounds of grain to make one pound of meat protein, chicken requires about 3 pounds of grain to produce a pound of protein, and so on.

In summary, rapidly growing demand for commodities often creates supply dislocations for a few years until adequate supplies of the required product or a substitutable product can be developed. This results in higher prices for the given commodity, until those new sources and supplies start producing.

INFLATION DRIVER #7: THE FUTURE SUPPLY OF SOME COMMODITIES, AND THE INFRASTRUCTURE TO DELIVER OTHER COMMODITIES, IS LIMITED. THIS IS ANOTHER DRIVER OF LONG-TERM PRICE INFLATION.

It is no secret that when commodities are less available and new resources become more scarce, their price is bid up. We have been proponents of the view that world oil supplies will not last forever, and only at increasingly higher prices will new oil be found. It seems that all the cheap oil has been found so the price mechanism has begun to ration the consumption of oil. In other words, less oil is being consumed as prices rise. This is often referred to as “demand destruction”. However, you may remember from our earlier note that most consumers of oil have been sheltered from oil’s big price increases by subsidy programs in their home countries…policies that do not encouraged conservation.

Oil and some other commodities may not be available for use in the long run, so new sources of energy will be required to power the world. Our concern is with what we see as the bigger problem; the infrastructure to power the world using other sources of energy does not exist. The current world energy infrastructure is primarily focused on fossil fuels: coal, oil and natural gas; and their delivery through pipelines, their refining, their use in heating, transportation, electricity generation, and many other areas.

It will not be trivial to create a new global infrastructure for an alternative energy solution. Most agree that the ‘new’ world will use a combination of nuclear, wind, solar, coal, battery, and other sources for electricity generation, heating, and transportation. This new world will not exist until the infrastructure has been built (at great expense, and at great cost in natural resources) to allow for the transportation and processing of raw materials needed, the transportation and manufacturing of the new equipment and devices, and for the efficient delivery of the energy to the end users. The time and resources required to build the infrastructure needed to harness new sources of power and to bring sufficient new supplies to the world will have inflationary effects.

Longer term, it appears that the rising cost of a unit of energy will continue to add to price inflation.

INFLATION DRIVER #8: WAGE INFLATION

WAGES ARE RISING QUICKLY IN THE DEVELOPING COUNTRIES

Although wage earners in the developed countries are not in a position to demand wage increases, the opposite is true in China, Russia, Saudi Arabia and other countries. The delivery of cheap consumer goods from China, Vietnam, Philippines, etc. to developed countries has created many jobs in these countries. Now with costs rising in their homelands, the workers in the aforementioned countries are in a strong position to demand higher wages from their employers.

Those of you who remember the inflation of the 1970’s will remember that wage increases in the U.S. and Europe, often tied to CPI increases that was one of the drivers of the inflation in that decade. Today the bargaining power lies with the Asian workers. Even in China, it has become obvious that there is not an unlimited supply of people willing to leave the farms for the cities unless wages rise enough to attract them. Thus, wage increases are rapid in Asia, Russia and the Middle East. Recently, China has admitted that wage inflation was 18% over the last year.

Most economists agree that the lower inflation rates globally from 2000 through 2007 were in part due to the lower cost goods delivered by the Asian nations. Now, a reversal of that trend is taking place. Higher inflation, driven by higher wage costs in the sourcing nations, will eventually make its way to all corners of the consumer world.

This is driver #8 for inflation, and another reason why oil and food are not the sole influences on the current inflation.

Thanks for listening!
Monty Guild
www.GuildInvestment.com