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Debating the Return of Inflation

When the world’s central banks decided to undertake a zero interest-rate policy and then to inject money into the global banking system to levels that were previously unforeseen, there was widespread fear that this would eventually unleash an inflationary firestorm. Our take was, and is, that these worries were misplaced because …

 

Navigating a Sea of Opportunity

Debating the Return of Inflation

Download newsletter in pdf formatWhen the world’s central banks decided to undertake a zero interest-rate policy and then to inject money into the global banking system to levels that were previously unforeseen, there was widespread fear that this would eventually unleash an inflationary firestorm.

Our take was, and is, that these worries were misplaced because the ability of the banking system to circulate or turnover this cash in the economy was broken. In the US, the velocity of money (the rate at which a dollar of bank deposits is able to circulate around the economy) is still dropping – almost six years after the near meltdown of the financial system. We have been watching the tug-of-war between the inflation and deflation sides and maintained that sometimes we can have neither. So far, that is exactly what we have.

Up until just a few months ago, the prevailing argument from central banks and economists seemed to have shifted toward the view that there was not enough inflation and the further weakening of inflation would be a dangerous development. The poster boy of what can happen when inflation gets too low is Japan where policy makers have been trying to stoke inflation and get the economy moving for over 20 years.

Given recent data we are beginning to consider the possibility that inflationary pressures are starting to surface. Unfortunately, central banks may be poorly positioned to contain inflation if they choose to cling to zero interest-rate and inflationary monetary policies for too long.

Central bankers will reduce inflationary policies as they witness strength in their underlying economies by reducing bond buying and perhaps by raising interest rates. Recent economic data does indicate a firming in economic growth.  In North America, labor data  shows unemployment falling and simultaneously businesses are signaling their intent to raise wages. Another data point for assessing the strength of the labor market that often goes unreported is the number of people who are voluntarily quitting their jobs. Recent US data shows that the number of workers who feel confident enough to quit their job to find other employment is at the highest level in six years with April 2014 data showing 2.34 million people gave their employers a notice to quit.

While these are standard economic variables that most garden variety economic discussions encompass, we have been watching another factor that we think could begin to impact inflation in a more consistent manner. That factor is food prices.

Food Inflation

Food prices have been on the rise for several years and since 2012 the pace has gained speed. Part of the reason for the increase has been related to weather and climate, diseases impacting certain crops and livestock and geopolitical uncertainty that has led to a rise in energy and other input costs for the agricultural industry.

Ordinarily, economists tend to look at inflation on two levels – the overall inflation level which includes food and energy prices and a core inflation number which excludes these often volatile data points The volatile nature of food and energy prices arises from the fact that they can be impacted by temporary phenomenon that quickly reverse course.

Global Currencies vs US Greenback

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Critics of this practice of looking only at the core rate of inflation often respond with sarcasm by scoffing at economists and central bankers by saying, “Of course there is no inflation – if you do not have to eat or drive”. The bigger question that seems to be getting some attention and debate is — What if the factors impacting food and energy prices are not transitory?  If food and energy inflation are persistent for long enough, then inflation will begin to creep into the core inflation numbers as well.

Critics of this practice of looking only at the core rate of inflation often respond with sarcasm by scoffing at economists and central bankers by saying, “Of course there is no inflation – if you do not have to eat or drive”. The bigger question that seems to be getting some attention and debate is — What if the factors impacting food and energy prices are not transitory?  If food and energy inflation are persistent for long enough, then inflation will begin to creep into the core inflation numbers as well.

Inflation’s Impact on Wages


Theoretically the way the inflationary creep would work is as follows: individual households would see an increasing amount of their income being devoted to food and not have as much left over for other spending. With their household budget under stress, they would demand or seek a better income level by asking for a wage increase or by changing jobs where possible. This causes disruptions to employers who might be faced with increasingly higher wage costs. Most economists agree that one of the great contributors to inflation is a sudden and persistent rise in wages.

Many countries have gone through periods of wage-price spirals – especially in the 1970s and 1980s. The wage-price spiral occurs when labor tries to overcome inflation by seeking and getting wage increases. In the past, wage-price spirals have come through either an overheated economy which is seeing little in the way of slack in the labor supply or shocks to the supply of food or energy. Recall, that in the core inflation numbers, food and energy are excluded.

MSCI Emerging Markets Index vs S&P 500

Chart Source: National Drought Mitigation Center
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The spiral takes effect when companies try to overcome the impact on their profits from rising wage and other costs by raising their prices. Thus, the wage/price increases can become self-reinforcing. If households are unable to get wage increases due to labor market conditions such as high unemployment or fear of job loss, then that household would have to make a tradeoff in how it spends its income. This would mean putting off purchases of non-essentials such as a vacation, new furniture or a new car. Undoubtedly, this would have an effect on the economy. In a normal scenario, if an economy slows down, inflationary and wage pressures tend to slow down too – albeit with a  lag. But if the underlying factors causing food and energy inflation are due to mother nature or geopolitical events, there is not much a central bank or government can do to curb the source of the inflation.

We are seeing the impact of mother nature on food prices in many parts of the world. Recently, Hershey Foods announced a nearly nine percent price increase for its products making for a nearly 17%increase over the last two years. Over the last year, cocoa  prices are up over 50%. Kraft Foods has also announced a price increase expected to impact 45% of the products it offers. Restaurant chains are trying to pass along the price increases they face for their ingredients to their customers. Earlier this year, US chain Chipotle stated in its financial disclosures that “the impact of inclement weather, natural disasters and other calamities … have impacted livestock and the supply of certain meats” prompting the company to respond with price increases for certain items on its menu.

Chipotle stated in its financial disclosures that “the impact of inclement weather, natural disasters and other calamities … have impacted livestock and the supply of certain meats” prompting the company to respond with price increases for certain items on its menu.

In North America, California’s drought is causing serious repercussions for the economy that could snowball if it is not reversed soon. California is the fifth largest contributor to the global food supply providing over 400 different crops. Some of the most fertile and productive land in California is in the Central Valley where water supplies are down by over 35% and the overreliance on ground water threatens future farm production unless that ground water supply is replenished by snowfall and rain.  Groundwater is providing about 53 percent of farm requirements from the usual 30-35% level. The entire state is now in severe to exceptional drought with estimates are that at least 5% of the farmland in California will be out of production next year.

Thirst for Water


Water supply has been a progressive challenge for a number of years but perhaps this year it is at its most acute in the last several generations. India and China are facing some of their most severe water supply challenges in history and both governments are trying to find a way to cooperate as the melting glaciers in the Himalayas have made a tough situation even tougher. Compounding the challenges on water supply from climate change is inadequate water infrastructure and pollution. In a surprising act of self disclosure, the Chinese government through state media declared this year that nearly 60% of its groundwater is polluted. This will impact its future agricultural output.

Perhaps in recognition of this challenge, China has been investing in and even acquiring US food companies. Recently, a Chinese company completed the largest Chinese takeover in corporate America on record with the nearly $5 billion purchase of US pork producer and processor Smithfield Foods.

Inflation is Far From Dead

While it would be jumping the proverbial gun to assume that the challenges of the last three years for the global agricultural industry are here to stay and inflation is around the corner, we think that it is an issue that warrants more attention than it seems to be getting. The potential impact from inflation on the economy and future interest rate policies is real and should be up for discussion. Thus far, it seems to be relegated to the back pages of many newspapers. At this point, we think it could serve as a warning shot to investors and policy makers that some types of inflation are beyond the remedy of central bank policies. If this issue were to get worse, we could see inflation make an unwelcome return.


  Pacifica Partners Capital Management Inc.

 

Navigating a Sea of Opportunity

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