A Leading Indicator Of The Coming Inflation?

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason


Allan Meltzer has called our attention to the fact that the US Department of Agriculture is forecasting food prices to increase by 3.5 percent this year.

This is the highest rate of increase in food prices in three years.

Meltzer warns that increases in food prices have been a leading indicator of inflation in past cycles.

Allan Meltzer, one of the leading economists of the monetary economics school, has put it out there for all of us to see.

"The U. S. Department of Agriculture forecasts that food prices will rise as much as 3.5 percent this year, the biggest annual increase in three years."

He closes his op-ed piece by claiming that "Inflation is in our future. Food prices are leading off, as they did in the mid-1960s before the 'stagflation' of the 1970s. Other prices will follow."

His reasoning: "Never in history has a country that financed big budget deficits with large amounts of central-bank money avoided inflation. Yet the U.S. has been printing money-and in a reckless fashion-for years."

The Federal Reserve's monetary policy over the past five years had done little or nothing to achieve accelerated economic growth during the recovery from the Great Recession. There has been very little growth in loans in the "regulated" part of the financial community. In one respect, loan demand has been very, very weak indicating that banks "didn't see demand to borrow by prudent borrowers." And, given the oversight of the regulators, the banks were extremely fearful to extend any loans.

A lot of the lending that has recently taken place has been for commercial real estate projects, but these projects are ones that were either re-financed from previously weak conditions, or were projects put on hold during the Great Recession. Nothing really new here.

In terms of mortgage lending, Meltzer points out… as I have done many times… there are very few first mortgages being issued. A large part of the lending taking place to finance real estate purchases has been to hedge funds, private equity groups, and large real estate companies that are borrowing to rent houses now. These loans are not showing up as residential real estate loans, but as commercial and industrial loans (C&I loans), making it look as if business loans were improving. However, the true story is that these C&I loans are staying in the financial circuit and not going into business investment that will spur the economy along. (See my post Commercial Bank Lending Still Not Supporting Economic Growth.)

And, this to me, is a very important point. A large part of the financial activity going on today is staying in the financial circuit of the economy and is not going to the production of goods and services. In a sense, the money flow is circulating above the "real" economy and this is why there is very little economic growth yet higher prices for assets like stock prices, housing prices, and commodities.

Consumer prices, what the Federal Reserve and others focus on in attempting to judge inflation, have not increased very rapidly at all.

But this is a result of the changes in the economic behavior of many large players in the market.

Sophisticated "money" people with lots of funds learn very quickly. Meltzer mentions how the inflation of the 1960s turned into the "stagflation" of the 1970s.

The governmental policy of credit inflation, started by the Kennedy administration in the early 1960s, which was followed by credit inflation of the Nixon administration into the 1970s, which was followed by the credit inflation of the Carter administration, which was followed by the credit inflation of the Reagan administration and so on and so forth.

Smart people learn that their actions need to follow something as pervasive as this continuous push of credit inflation for the past fifty years and more.

What did you see in the 1970s? People began to hedge against inflation by buying homes, purchasing gold, and acquiring art. All assets. And, then they became more sophisticated and used other types of assets as inflation-hedges.

And, what was the general rule within an environment like this? Go into riskier assets, increase financial leverage, and create new types of financial instruments… financial innovation.

This kind of behavior, however, is not picked up in the macroeconomic models used by the Federal Reserve and the federal government. As Meltzer points out, the Fed is still using the Phillips Curve to forecast inflation. This model was originally produced in the 1960s and is practically useless today… yet, as Meltzer writes, it is a major policy tool.

This change in behavior resulted in what was called the "Great Moderation." The Great Moderation began during the mid-1980s when major economic variables such as real gross domestic product growth, industrial production, monthly payroll employment and the unemployment rate began to decline in volatility. This continued up until the Great Recession.

What I see during this time is the growth in financial innovation, the growth in employment in the financial industry, the growth in the shadow banking industry and so on. More and more activity in the economy was solely financial in nature and didn't spill over onto the "real" production in the economy. Hence, volatility declined in "real" production, while volatility increased in the financial sector.

And, what do we see taking place now? A search for greater risk to provide higher yields, a set back up to higher financial leverage in those people and organizations "playing the game," and a return of most of the financial innovations of the past thirty years along with some new ones.

And, what else has happened over the past fifty years or more? A tremendous growth in income inequality!

The wealthy can play the games I am talking about. Others cannot. Keynesian economics has provided more benefit to the wealthy than anyone else. And, remember Keynes, who was wealthy, developed his economics to protect countries like England from experiencing Bolshevik revolution. He wanted his class to prosper and live in peace and didn't want to be disturbed by discontented working classes.

Meltzer is raising a red flag. Whereas many people have profited greatly from the economic policies of the last five years, many others have suffered with wages remaining stagnant, labor force participation falling to its lowest level since March 1978, and capital utilization, at its current peak being at it lowest "peak" level since the series was started in the middle 1960s.

Within this environment, if food prices begin to rise, suffering can only increase. And, if Meltzer is correct, the rise in food prices is really only the start of more "consumer" prices beginning to rise… then the largesse on the part of the Federal Reserve over the past five years could really be worrisome.

The projected rise is food prices is only, possibly, a leading indicator. We should now be on the watch to find any more early indicators that inflation is actually starting to rebound. If this were to be the case, then it will come to dominate the next ten years or so and should be taken into account by every investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.