Angry At High Food And Gas Prices? Blame The EPA Not The Fed

Before you read this article, watch this video. I wrote this article over the weekend and this is that video is hitting the press today. It pretty much validates much of what is written in this article. Ethanol, Ethanol RINs and the biofuels industry is sure to have added scrutiny applied to it if stories like the one highlighted in the above linked video keep hitting the news. As I've always maintained, political risk will always be the greatest threat to these companies, and current market events won't help maintain public support.

One of the main sources of hostility towards the Fed is high food and energy prices. People see these staples of life taking a larger and larger percentage of their disposable income and are justifiably angry. They then see that the labor department subtracts food and energy from their "core" inflation measure and the conspiracy theories explode. Clearly with that evidence the labor department and the Fed are conspiring to deceive the America people. There can be no other explanation. The "banksters" from Jeckyll Island are in cahoots with the unions to loot the American people through the hidden inflation tax that has robbed the American people of 95% of its wealth.

I hear these arguments all the time and they are all nonsense. The chart above is true only for a US Dollar that was earned in 1900 and placed in a non-interest bearing vault for 100 years then spent. That rarely if ever happens. In reality that US Dollar would have been earned in 1900 and spent within a week or so experiencing no inflation at all, or would have been placed in an interest bearing account that would compensate the owner for any inflation that may occur. The facts are both wages and inflation have increased over the last 113 years resulting in standards of living being infinitely higher than they were in 1900. As long as wages outpace inflation so that real wages grow over time, the cost of inflation are far outweighed by the benefits of a rising standard of living. Mild inflation allows for full employment and maximum production. Deflation on the other hand results in high unemployment, high real interest rates and falling productivity, economic growth and standards of living. The period of deflation identified on the chart above is the Great Depression, so clearly the people using that chart to make their case don't understand its meaning or their economic history and basics. Those misunderstandings have resulted in some pretty bad policy proposals, and have unjustly maligned the Federal Reserve and undeservedly undermined its credibility and independence.

The problem is, there are multiple causes of inflation and "printing money out of thin air" is only one of them. Inflation is defined as "too many dollars chasing too few goods." Contrary to conventional wisdom, inflation is not defined as simply "printing money." Unfortunately Webster's Dictionary accidentally added credibility to this misunderstanding. While people continue to debate the definition of inflation, there is only one definition that matters when discussing investments, and that is the definition used by the markets. Every bond is priced with an implicite estimate of inflation factored into its value.

The key word in the definition of inflation that critics of the Fed seem unwilling to accept is "chasing." Printing dollars does nothing to the inflation rate unless those dollars are put to work chasing/buying goods and services. The newly printed dollars must alter the supply and demand dynamics to generate inflation. That has not happened since 2008 crisis and the resulting QE-infinity and that is why we still have low inflation and slow growth even after "printing all this money out of thin air."

In reality there are two types of inflation, supply shock and demand pull inflation. A supply shock inflation is represented by a leftward shift in the supply curve, and demand pull inflation is represented by a rightward shift in the demand curve.

With supply shock inflation there is a sudden and/or sustained reduction in aggregate supply of goods and services. The classic examples are the oil embargos of the 1970s, droughts, natural and unnatural disasters. In the 1970s OPEC created an oil shortage which sharply shifted the supply curve of oil to the left, dramatically increasing its price. Because oil is such a critical commodity involved in so many products, and is often a major cost component in their production, the oil embargo had the ability to shift the entire aggregate supply curve of the US to the left. The Federal Reserve and monetary policy are impotent in regards to fighting supply shock inflation. Any effort they make would worsen, not improve the situation. If they tighten the money supply and drive up interest rates to cool prices, demand will fall resulting in a worsening unemployment and stagflation that likely exists. If they print money to ensure there are enough US Dollars to purchase the now more expensive products, it simply results in more demand and higher inflation. Basically there is nothing the Fed can do, nor is it responsible for inflation that is caused by supply shocks like droughts, embargos, wars and disasters. All they can do is attempt to minimize the costs.

Demand pull inflation is the good kind of inflation if it is controlled and maintained at a very moderate level. That is why the Fed targets 2% inflation. Mild inflation is characteristic of a healthy, growing, stable, full employment economy. People are working, jobs are being created, wages are increasing, standards of living are improving, productivity is growing, capital is accessible and new products are being invented and sold. Ideally economies want demand to just outrun supply, creating mild inflation and an incentive to grow to meet the increased demand. The problem with demand pull inflation is if the demand pulls too hard to create inflation that does more harm than good. The Weimar Republic is the classic example, where the German government would print money to buy goods and services to hand over to the French as war reparations. Goods would fly off the shelves as fast as the German government could print money. That is when "printing money out of thin air" becomes the cause of hyperinflation, when the central bank functions as a tool to directly finance fiscal policy. That is why the Federal Reserve was created as an independent body shielded from political pressure and prohibited from buying bonds directly from the US Treasury. The Federal Reserve must purchase their assets on the open market and asset purchases must be made consistent with their duel mandate of full employment and low inflation.

Those are the basics, now back to the original topic of this article. Thanks to fellow Seeking Alpha author Tristan R Brown's article "Refiners Should Get Used To The High RIN 'Tax'" I was able to find a "smoking gun" article to make my case. I have always maintained, as does Ben Bernanke, that fiscal policy, not monetary policy is the cause of our economic problems. Mr Bernanke goes into more detail in this video. The facts are, much of the inflation in our economy is due to non-monetary issues, namely fiscal policy. The fiscal policies disproportionably impact food and energy prices, so if you are angry about food and energy prices, don't blindly direct your anger at the Fed, focus it on the real cause of the problem, congress and the Whitehouse.

Tristan's article's title highlights one source of the inflation, the RIN "tax." The EPA's Renewable Fuels Standard 2 (RFS2) and their Renewable Identification Number (RIN) system effectively impose a "tax" on the energy sources most of us use. That RIN tax is then passed on to the consumer. Believe it or not, the mechanism being used to solve our energy problem isn't to develop conventional energy sources like we did in the 1980s which resulted in greater supply and lower prices, the objective today is to drive the price of conventional energy so high that alternative energy sources become economically viable. Basically it is supply side economics in reverse. Instead of OPEC, today we have the Federal Government restricting fuel supplies and driving up costs.

Yea, I know, I sound like I'm a conspiracy theory nut job whose tin foil hat is too tight. Fortunately, the people pushing these policies don't even try to hide this economic strategy. Al "An Inconvenient Truth" Gore outlines this strategy in his book "Earth in the Balance," and President Obama left no doubt as to his intentions about implementing the strategy...and he has. By the way, before you go out an invest in all these "green" anti-carbon solutions to save the earth, you might want to study the science backing this "concensus" of scientific thought. Global warming ended over a decade ago, and the only mechanism defined by these climate 'scientists" for CO2 to affect climate change is through trapping heat and causing the green house gas effect. Without warming, how in the world could CO2 possibly be causing what climate change we are experiencing?

Here is a news flash...it doesn't. Never in the history of the earth has there been a period when climate change wasn't the norm. Egypt used to be the bread basket of the world, Romans made wine in northern England, Vikings inhabited Greenland, the little ice age contributed to the French and American revolutions, the coming ice age of the 1970s fad faded until the global warming of the 1990s and that morphed into the climate change of today. The concept of using CO2 as a boogieman to scare people into action to save the earth isn't new, and was outlined during something called the "Iron Mountain" meeting arranged during the JFK administration as an anti-war strategy. The theory was if world leaders could manufacture an external threat to unify all the people of the globe to fight against, they might start fighting the manufactured boogieman instead of killing themselves in wars. While there is a debate as to its authenticity, what is so interesting about the Iron Mountain meeting is that YouTube has videos made about it back in the 1970s, 80s and early 90s made during the "coming ice age" and pre-global warming period describing many of the policies today and the framework for the global warming scare. Even if it was a hoax, it accurately predicted using CO2, pollution and global warming as some of the potential external threats and would represent one of the most accurate examples of life imitating art I've ever seen.

Fortunately I don't need to rely on YouTube videos to make my case, the USDA puts it all in writing for me. From this USDA report it makes it very clear that biofuels policies have driven up the price of food. Higher food prices are known, expected and accepted costs of these policies. Note how "climate change" is used as justification for these policies.

To reduce dependence on foreign oil and to address climate change
concerns, U.S. policymakers have introduced a combination of policies to support the production and consumption of biofuels. An important element of U.S. biofuel policy is the Renewable Fuel Standard (RFS).

Ironically, past policies used to reduce the cost of energy to the consumers. Today's policies do just the opposite.

Over the years, policymakers have introduced different policies to support the production and consumption of biofuels (Duffi eld et al., 2008). The National Energy Act of 1978 gave ethanol blends of at least 10 percent in volume a 40-cent-per-gallon exemption from the Federal motor fuel tax.

Some of the past policies actually lead to an increase in pollution. The law of unintended consequences seems a constant when analyzing EPA regulations.

The Clean Air Act Amendments of 1990... Congress mandated the use of oxygenated fuels in specific U.S. regions during winter months to reduce carbon monoxide emissions. The two most common ways to increase the oxygen content of gasoline are
to add methyl tertiary butyl ether (MTBE) or ethanol... environmental concerns about MTBE led many States to ban its use.

With the 2005 Energy Policy Act the regulations transformed from using carrots to using sticks. Tax incentives were replaced with quotas. The actual 2012 ethanol quota was 13.2 billion gallons. It is 13.8 billion gallons for 2013, and partially responsible for the spike in RIN prices.

The 2005 Energy Policy Act...This act also created the RFS program, which initially mandated that 4.0 billion gallons of renewable fuel be blended into gasoline in 2006 and increased to 7.5 billion gallons by 2012.

One important point highlighted in the USDA article that is most important to investors in biofuels is that the RIN structure "ensures that the mandate is met." What that means is that profits are "ensured" by the US Government in quantities necessary to 1) reach the annual quota 2) attract capital to expand capacity to meet the future quota levels and 3) keep the industry functioning as long as the RFS2 is in place. This doesn't guarantee that any one firm will survive, but the entire industry has the backing of the Federal Government.

The RIN Market Ensures that the Mandate Is Met
The RFS2 mandate could be met by each obligated party blending their required volume of biofuel and reporting those RINs to the EPA. However, a market for RINs has been established to facilitate the trading of the RINs.

This graphic from the report highlights how the mechanism works. The take home message is that 1) the RINs guarantee that the fuel is profitable as long as the quota is above the equilibrium production level and 2) the inelastic nature of a quota almost ensures that the RIN market will be volatile and subject to manipulation. Like gold and Bitcoins, anytime you can horde an item, you can expect volatility and manipulation. "Big Oil" has an inelastic demand for these RINs. The classic example of an inelastic demand is a heroin addict because they will rob, cheat and steal to get the resources to buy their heroin. Those kinds of markets are invitations for exploitation. That is why I would expect RIN prices to be going higher in the future once they become better known and their availability of the exchanges grows. Already the Ethanol RINs are up over 2,700% year to date. With that kind of blood in the water, the sharks are soon to follow. By the way, I can't resist pointing out that our government created this system to help the energy consumers. How they overlooked these "unintended" consequences is way beyond me. They obviously have learned nothing from the last bout of RIN fraud, but why should they? We keep re-electing their bosses. Repeating failure seems to be a winning campaign platform.

Believe it or not, this RIN mechanism is designed so that biofuels prices do not fall as crude oil falls. The whole purpose is to keep the biofuel expensive enough to keep it in production. "Big Oil" then has to buy this more expensive fuel to blend into its conventional fuel, and the higher cost gets passed on to the consumer. Lowering the cost of fuel to the consumer isn't part of the RIN calculation. The whole purpose is to keep the price higher than conventional fuels. Unfortunately that isn't a joke. The "beauty" of a quota system is that the consumer has no choice, the iron fist of the EPA dictates consumer choices, not the consumer.

When crude oil prices drop, consumers' willingness to pay
for biofuels decreases. The demand curve for biofuels shifts downward, and prices for RINs increase.

I was having a bit of fun above with the obvious "unintended" consequences of allowing speculation in the RIN markets, and the likely bubble that will form. That flaw is extremely obvious and well known, and even anticipated. The problem I have with it is, if it is a well known flaw, what is being done about it? Allowing mortgage lenders to make loans with "no skin in the game" was a known flaw that "securitization" of pools of these mortgages was supposed to correct. Well, we all know how that turned out. I would replace the word "potentially" with the word "certainly" in the following quote. By the way, did I mention that ethanol RINs are up over 2,700% year to date? Couldn't have seen that one coming now could we?

Speculative Component
Speculators who register with the EPA are allowed to buy and sell RINs...This process could potentially reduce the number of RINs available for the current year's compliance and increase RIN prices.

Back to the original subject of this article. Corn ethanol production has diverted corn away from being used as a food, to being burned as fuel. It is estimated that ethanol production consumes 40% of more of the US corn crop. That drives up the cost of corn, but also drives up the cost of other foods as their supplies shrink as farmers replace acreage once used for food with corn for fuel. This doesn't only drive up the cost of fruits and vegetables, but also beef as their feed becomes more expensive. Ethanol not only drives up the price of fuel, it is highly disruptive to the entire food industry.

Corn serves as the predominant feedstock for U.S. domestic biofuel production. During the last 3 marketing years, corn used for ethanol production as a share of total corn use has increased from 24 percent to 37 percent. Increased use of corn for ethanol production has raised corn prices, which has reduced other domestic usage and exports. The decrease in corn for livestock feeding is partially offset by the increase in distillers' grains in livestock rations...Greater U.S. demand for corn has contributed to higher corn prices rose from $2.00 per bushel in 2005/06 to an estimated $5.20 per bushel for 2010/11. Higher corn prices have also encouraged producers to increase their corn acreage. U.S. cropland planted to corn increased to 93.5 million acres in 2007, the highest level since 1944. Some of the increase in land planted to corn has come from other crops, affecting the markets of all field crops. Despite increased corn plantings, corn usage has outpaced production growth, reducing carryover stocks.

The USDA admits ethanol policy drove corn, by far the most influential foodstuff on the market, from $2.00 to over $5.00, and yet many scream at the Fed for driving food prices higher. Clearly, if angry consumers want lower food prices they should be screaming about repealing the ethanol regulations, not changing monetary policy.

I must however give the USDA some credit. They were dead on with this comment. Ethanol RINs have certainly experienced some "variation."

USDA's 2011 baseline projections suggest that conventional ethanol RIN prices could experience some variation in the next 10 years, as the impact of the RFS2 on corn markets varies from year to year.

In conclusion; the this USDA report pretty much proves beyond any reasonable doubt that higher food and energy costs are largely a manufactured phenomenon, created by fiscal not monetary policy. Investors that base their investment decisions upon the understanding that inflation is caused by "printing money" and is being caused by the Federal Reserve simply have it wrong. Many investors in gold/SPDR Gold Trust (GLD) and silver/iShares Silver Trust (SLV) are finding that out the hard way. This USDA report also highlights what I view as the greatest threat to the biofuels industry, political risk. The RFS2, EPA quotas, tax credits and clean air laws are all political constructs depending upon political support, and can be totally erased with a stroke of a pen or landslide election. Ethanol RIN prices increasing 2,700% in a matter of months is sure to wake up the political opposition. If that trend continues, it will likely threaten the entire system as previously disinterested people start to look under the hood like I did in this article. I find it hard to believe these policies will maintain support with the average American if they took the time to understand them. Facts are, if the average voter decides they want lower food and energy prices, the quickest and easiest way to reach that goal is to repeal the ethanol laws, allow the keystone pipeline to be built, drop the carbon regulations directed at bankrupting coal burning power plants and expand drilling on federal land. The one policy that is 100% certain not to impact the price of food and energy is to "End the Fed" and continue blaming the Fed for inflation over which it has no control.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

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.