The Case For Further Inflation

In my previous entry, which can be found here, I briefly touched on my thoughts on inflation. Today I would like to spend a little more time explaining some of the macroeconomic factors that I believe are currently converging that could lead to a dangerous increase in the rate of inflation in the future. These factors include the increase in energy prices, the weak dollar and current US monetary policy.

The most straightforward inflationary factor that is contributing to the threat of inflation is the seemingly unrelenting rise in oil prices and other commodities. The surge in oil prices is reminiscent of the stagflation during the 1970s caused by the '73-'74 oil embargo following US support for Israel during the Yom Kippur war. Rising energy prices across the economy led to rising prices overall and became the quintessential example of “cost-push” inflation as the cost to produce and transport products increased dramatically.

Adjusted for inflation, the price of oil reached $105 in 1980, which is less then the current price of a barrel of oil, which stands at around $124. In order to understand the effects of the most recent rise in the price of oil we must take into account the percent of GDP that can be attributed to oil expenditures. In the early 1980s, oil expenditures topped out at 8% of GDP; in 2000, before oil undertook its most recent run-up oil expenditures bottomed out at about 3.5%.

However, the price of oil averaged about $28 in 2000. Today, oil prices stand at about 4.5 times the price of oil in 2000. This run up has naturally had a significant effect on our economy and has resulted in an increase in the percentage of GDP consumed by oil expenditures. In 2008, the U.S. economy had a GDP of approximately $14 trillion; this is compared to a GDP of $10 trillion before the rise in the price of oil that began in 2000.

Now for some rough math, if you multiply 3.5% (the percent of GDP taken up by oil expenditures in 2000) by 4.5 (the increase in the price of oil from 2000 to 2008) you get 15.75%. If you then multiple this number by $10 trillion divided by $14 trillion (or just 10/14) you can then account for the economic growth between 2000 and 2008.

The resulting figure is 11.25%, substantially above the 8% that occurred during the 1970s. Therefore, we can plainly state that if oil remains at these high levels for the remainder of the year, the percent of GDP spent on oil expenditures will likely surpass the former peak that was achieved in the early 1980s. As a result, it should be clear that rise in the price of oil is clearly inflationary and could lead to similar inflation problems as the ones that occurred in the 1970s and early 1980s.

In addition, it is worth noting that the rising oil prices of the 1970s was caused largely by an oil embargo, an event that did not last forever. Today's rising oil prices and the prices of all commodities in general has been caused by an inability of the oil drillers and other producers to keep up with the rising demand for oil and the other commodities from China, India and the rest of the developing world. This situation could improve as new production sites come online but there is only so much oil and other commodities out there. The recent economic growth put on by China, India and the other developed countries will not subside in the future and will not go away as the oil embargo did.

Another factor impacting the price of oil is the weak US dollar. A weak dollar affects more than just the price of oil though as it increases the cost of all other goods that are imported from overseas. The three most important factors impacting the value of the dollar are the trade deficit, the level of US interest rates relative to rates in the rest of the world and the US economy in general. These factors all point to a weak dollar for the next six months to a year, as it will likely be only then that some of these variables begin to change.

When the trade deficit is negative, it means that on balance more dollars are being traded for foreign goods than foreign currencies are being traded for domestic goods. As dollars are being moved overseas, foreign companies have then had to trade their dollars for their own currencies, forcing them to sell their dollars. This has put downward pressure on the price of the dollar and has helped to keep it down. The trade deficit is still near its all-time high and does not appear to be shrinking. This is partially driven by the fact that the US imports so much oil, and the higher the price of oil goes the larger the trade deficit becomes, limiting the effect of increased exports caused by a weak dollar.

Low interest rates in the US also put downward pressure on the dollar. This is because investors will tend to want to invest their money in countries with higher interest rates rather than in places like the US with low interest rates. In addition, the downward trajectory of the dollar versus the upward trajectory of the euro further impacts the returns that investors receive, pushing investment flows away from the US and towards other countries.

The dollar has been falling for the last three plus years; however, the prices of foreign goods have not skyrocketed. This is primarily because foreign manufacturers, in an attempt to maintain market share, have let their profit margins shrink. It is doubtful that this trend will continue as countries begin to reexamine their own currency policies. China’s recent actions that have allowed the yuan to appreciate is but one example.

The final driver of inflation is US monetary policy. The Federal Reserve and Bernanke are stuck in a very difficult situation where they have been forced to cut interest rates and increase liquidity not because the US economy is in a recession but because of the burst housing bubble and the related credit crunch in the banking system. If the entire economy was doing poorly, then a stimulative monetary policy would be a warranted. However, when most of the economy is doing fine and only a handful of sectors needs stimulation, you are forced either to stimulate the entire economy or not to stimulate anything.

In trying to fix the credit crises Bernanke has been forced to allow inflation to creep higher in other areas of the economy, proving the point that there is no such thing as a free lunch. A direct result of Bernanke’s low interest policy will be an increase in inflation. I agree that allowing the banking system to fall apart is completely unacceptable and that Bernanke is using the correct approach; nevertheless, as with any government policy there will be unintended consequences.

Bernanke and Greenspan have both used stimulative monetary policy to fight the problems plaguing the economy during their tenures. Greenspan used it to fight the deflationary effects of rapid productivity growth and job outsourcing, and Bernanke has been using it to help solve the credit crisis and the pain associated with the housing bubble. However, just as Greenspan’s policy had unintended consequences, so will Bernanke’s, and that is why as investors we must be aware of the strong possibility that inflation will creep higher in the year ahead.

If the Federal Reserve is successful in combating the credit crisis and the asset bubble, the corresponding inflation may not be a bad thing as the Federal Reserve will be forced to raise interest rates. This will in turn strengthen the dollar, lower the price of commodities and encourage foreigners to invest in the United States.

For Further Review:

Department of Energy Website

Comments

[Skjellifetti]

The resulting figure is 11.25%, substantially above the 8% that occurred during the 1970s. Therefore, we can plainly state that if oil remains at these high levels for the remainder of the year, the percent of GDP spent on oil expenditures will likely surpass the former peak that was achieved in the early 1980s. As a result, it should be clear that rise in the price of oil is clearly inflationary and could lead to similar inflation problems as the ones that occurred in the 1970s and early 1980s.

You have failed to account for the reduced demand caused by the increase in the price of oil. You simply can't take a linear extrapolation of a non-linear phenomena and expect to get anything close to a meaningful result.

[rocksteady]

until alternative energy solutions are readily available, oil will have an inelastic demand. so the case for reduced demand in response to higher oil prices doesnt really factor into the equation.