An investor’s position in the market is a function of their belief in the general trend of the economy. Bond holders have to be aware of the counter-party default risk and the yield relative to the risk free rate return plus inflation. With QE2 occurring in the US, any bond holder has to be very concerned with inflation and the increasing of interest rates. Commodities investors are also affected by inflation; as a country attempts to control growth they restrict the money supply, which decreases output and demand for the inputs of production. Understanding the impacts of monetary and fiscal policy is paramount if risk is to be properly assessed. For most people their decision will be based on what they are told by expert’s appearing in the media. As far as monetary policy is concerned the amount of criticism in the media makes one believe the Greenback will be used as a substitute for Scotties two-ply. As an objective investor you must question the current view of the circumstances. Most of the criticism centers on the notion that Ben Bernanke wants to monetize the debt. This is laughable at best; around 5 of the 14 trillion currently owed by the federal government in intergovernmental debts, the bulk of remainder matures in 10 yrs or less and another 600 billion is inflation protected. Monetization would hurt the countries reputation and cause massive capital outflows while having little effect at reducing the real debt burden, which would be the desired outcome of the policy. This would suggest that the panic is in fact manufactured; the media constantly citing core CPI is an inconsistent measure of inflation, since removing food and energy doesn’t make sense. Unfortunately the argument that Hyper-inflation is almost here is flawed; I can state with certainty that core inflation is in fact the best measurement of controllable inflation. My reasons are as follows:
1) No central bank can control supply or demand shocks in a given marketplace. A shock occurs because some unforeseen act restricts (creates) supply or demand sufficient enough so that no instantaneous market mechanism can correct for it. If frost kills all the oranges in Florida the result would be a price increase in oranges and their substitutes. The aggregate demand for “fruit” will decline because of an income effect, while demand for apples, pears and bananas increases. The resulting food inflation is as a result of efficient markets not loose monetary policy. Oil supply is tightly controlled and there are no short term substitutions, if a supply shock occurs the demand will remain almost the same which will increase prices. Again this has nothing to do with loose monetary policy. The easiest test to see if lose monetary policy is the cause of inflation just examine Canada or Mexico. Both countries have independent monetary authorities, measure CPI in the same manner, and at least in the case of Canada, have started tightening the money supply. Food and energy prices have increased in Canada (as measured by their CPI), despite the greenbacks depreciation against the Looney. That would suggest demand is outpacing supply, not simply being revalued in terms of a depreciated currency.
2) The CPI is biased towards over prediction of inflation, through its construction. The survey measures a basket of goods purchased throughout the country. It assumes there is no change in consumer behavior (going to Costco vs. Super Value), that there are no new substitutes arriving to market (discounted store brands or new competition in the space), that the quality of the good has not changed (1999 Ford F-150 is the same as a 2011), and that the demand for products has remained the same. A quick consideration of these factors suggests that (besides making a really flawed survey), real decreases in prices due to increased competition, new product substitutes, and quality improvements are not factored in to the calculation.
With this in mind two questions arise: When is the inflation going to happen? What should I be invested in? I will answer these questions in my next post.