Saturday 16 May 2009

Why inflation will rise.

Earlier, I posted the most recent University of Michigan survey on US inflationary expectations. The number has recently ticked sharply upwards, indicating that people expect prices to rise.

Almost as soon as the post was completed, I received the following comment:

What sector of the economy has pricing power outside of the light ammo industry? Has the spare capacity or supply been used up in the housing market, commercial real estate market, auto manufacturing plants, existing autos (we have far more than we need on the road already), or the financial industry (which should be shrinking far fast than it is)?

UMI must be surveying economists or other such idiots.


It is a fair question that deserves an anwer.

Recessons have a well understood dynamic pattern. The process starts with a fall in aggregate demand. Firms begin to accumulate inventories, a sure sign that a recession has begun. Initally, firms will be reluctant to fire valuable workers with their firm specific skills. This is called labour hoarding. However, hoarding, rising inventories, and declining sales put enormous financial strain on companies, particularly badly run ones. Revenues are falling, but costs remain high. Eventually, firms start firing workers, while weaker businesses go bankrupt.

During the early stage of a recession, there is significant downward pressure on prices. Faced with those huge stockpiles of unsold goods, firms discount heavily and inflation comes down. The discounting does the trick insofar as firms empty out their warehouses. It does little to promote growth or stabilize employment.

When the recession really begins to hold, two conflicting pressures emerge. On the one hand, as firms go bust, the supply side contracts and supply chains are disrupted. firms go bust, the supply side of the economy contracts, and supply chains are disrupted. If a factory closes, the spare capacity disappears completely. A bankrupted firm has no influence on prices at all.

On the other hand, unemployment continues to rise. Initially, people without work will run down savings, which will in part, sustain demand. Eventually, savings run out and demand will begin to suffer.

These two forces will fight it out as the recession matures. Eventually, firms will have reduced their inventories to a minimum, the discounting will stop stops, and profit margins will recover. At this point in the cycle, the downward pressure on prices abates. Inflation stabilizes, at a high level of unemployment.

Eventually, the lack of inventory, along with the disappearance of weak firms, and capacity contraints will create the basis for an economic recovery. The key message is from all of this is leave the private sector alone and it will sort the recession out by itself. It may take time, but growth will return.

However, the UK and US governments don't have the patience for natural self sustaining private sector led recovery. Instead, they want unproductive and wasteful public sector expenditure to sustain demand. They believe that governments can stabilize economies better than the market. It is an arrogant and conceited belief that has been repeatedly exposed by history. Nevertheless, politicians love intervening.

The Fed and the BoE have also joined the game. They have cut interest rates to almost zero and pumped out uncountable trillions into insolvent banks. In the case of the UK, the central bank is now actively financing the unsustainable fiscal deficit.

Of course, this policy activism has done nothing to support economic growth. Both economies have crashed, with GDP growth likely to fall by about 4-5 percent this year. More surprisingly, inflation, particularly in the UK, has proved to be rather sticky downwards. Insofar as inflation has fallen, it has been due to falling commodity prices, particularly fuel.

However, the private sector is not totally stupid. When it considers the economic future; it sees three things; a collapsing supply side of the economy; a massive increase in wasteful public expenditure which will inevitably lead to higher taxes and a large dose of irresponsible monetary growth.

Will this lethal concoction cause inflation to increase next month; maybe; maybe not. Will it cause inflation to rise sharply in 2010? Absolutely; hence the April rise of inflationary expectations.

15 comments:

Sackerson said...

Excellent - you make the process very clear to me.

JohnofEnfield said...

How Darling has the brass neck to stand up and say...

1. There will be a planned budget deficit of £175 BILLION in 2009/10.
2. The deficit will reduce to £173BILLION in 2010/11.
3. we will keep spending this way until we are re-elected!!!!!


...I do not know.

Alice Cook said...

Sackerson,

Thank you for your kind words.

They are much appreciated, along with your wonderful bearwatch blog.

Alice

sobers said...

It suddenly occurred to me that there is something of a similarity between the £150bn the BoE has apportioned for QE, and the £175Bn the govt need to raise in 2009/10. Basically Labour now know that there will be no funding crisis before the next election. They can spend on, safe in the knowledge that Mervyn will continue to buy the bonds in the marketplace.

Of course after the next election is a different matter. At some point the BoE will have to try and sell its £150bn of bonds back into the market just as Dave & chums are trying to raise large sums themselves. Not a pretty scenario.

I reckon its all part of Gordons scorched earth policy. Leave nothing standing for the Tories to inherit, even at the expense of the nations finances.

Alice Cook said...

Sobers,

WAKE UP!!!!

That is exactly what QE is about.

Alice

Acorn said...

Alice, do you have any idea what the real UK GDP is? I can get anywhere between £1236 billion and £1450 billion on various web-sites.

As Many stat's are quoted on a GDP basis, this has to be a number worth a bit of government (ONS) fiddling.

Is it true that it is normally quoted by government at "market prices"? This makes the public sector bit look smaller. A better measure is "factor cost" and a lot of GDP isn't real money, such as the inclusion of a imaginary rental value for an owner occupied house.

Anonymous said...

Alice, You don't answer the question you pose. Namely "what sector of the economy has pricing power".
Maintaining the public sector with debt while the private sector shrinks is -not- maintaining demand. Demand is still going down unless you think the public sector has expanded equivalent to private sector shrinkage, which is not the case.
The situation in 2010 will be characterised by a higher level of unemployment than today, perhaps with higher borrowing costs.
So, which sector is it that can raise prices?
There isn't one, which I think was the point of the original poster.

Fred said...

Your analysis of the dynamics of recession is very good.

Part of what strikes me about the current phase is that a lot of folk are being made redundant and getting settlements as they leave. For now, they are still able to pay their mortgages but ... that won't last. (And lets face it - these are the responsible people and not the sub-prime sector).

Josh said...

Got GOLD ? It is the ONLY protection be it inflation OR deflation. Silver in the UK carries VAT, a revolting tax on a monetary metal/currency.

Anonymous said...

Hardly that Josh. You don't pay VAT if you buy second hand silver, so you could argue that VAT supports the price of existing silver holdings.

Alice Cook said...

Anonymous,

I will give you one sector - the car industry. At the moment, car manufacturers can not give their products away. Stocks are accumulating, and there are heavy discounts available.

The industry is on the verge of a major supply contraction. Chrysler is in chapter 11, GM will follow by early June. Both firms will shut down factories everywhere.

Eventually, supply will become tight, and car manufacturers will be able to pass on price increases.

However, this contraction, which we see today, is accompanied by a huge increase in liquidity. We have also have huge fiscal imbalances that will last for years. This will create nominal demand that will lead to higher inflation.

Anyway, that was my quick response.

Alice

Alice Cook said...

Acorn,

Honestly, I don't think the ONS are fiddling the GDP numbers. There are different concepts, such as the one you mention - factor cost, and there are others like market prices.

Numbers will also vary as the ONS provides better estimates. The ONS is actually independent of the government and on occasions it has honourably challenged the government on its misuse of stats (eg knife crime). In sum, I trust the ONS.

As for the GDP number, I would have to look it, which I will do when I have time.

Alice

Anonymous said...

The government long ago decided to hyperinflate its way out of the crisis. Hyperinflation, for a bankrupt government, of course has many advantages. The young will be fine because they can work their way out of debt; the old will be screwed, but then they built the nasty old world we live in, so they kind of deserve it. All I know: I am raising my fees and rates in anticipation of this.

Anonymous said...

Health care is probably another segment that still retains pricing control. But anon's point is well taken that for the near term it is hard to see price inflation. Alice is correct in the medium term.

The trillion dollar question is how many months/years define short and medium.

The only other issue on inflation that has not been addressed comes from currency fluctuations and the resulting price impact on imported commodities. This can cause price inflation irrespective of demand inflation.

IN the case of the UK and the Pound, this is a very real inflationary danger IMHO.

fajensen said...

So, which sector is it that can raise prices?The Public Sector: You will pay your taxes or be made to pay!