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Donít Believe Everything You Read Ė Inflation is NOT Peaking

James Groth
October 25, 2011, 1:14pm

Despite what headlines have been touting about falling commodity prices and the easing of inflation pressures, reporters should check again, prices are rising.  The recent fall in commodities is nothing more than a short-term blip. Reports like this one from Bloomberg: “Inflation Peaking in U.S. as Commodity Prices Tumble” measure data that was reported at the end of the last quarter which came to a close on September 30th. Let’s check the price of key commodities since the first day of trading in October:

Crude Oil: up 24.8 percent

Corn: up 13.6 percent

Coffee: up 14.1 percent

Orange Juice: up 18.6 percent

To reiterate, this is the amount these commodities have appreciated over the last three weeks alone.

Any drop in these commodities that was viewed as inflation pressures easing in the last quarter, now must be viewed as inflation pressures skyrocketing. Having a short-term view on the commodity prices is asinine given the pace at which prices fluctuate. The advent of new trading products like derivatives and ETFs, not to mention a hoard of cash being directed towards these assets because of a dearth in alternative assets for traders to trade, has created massive volatile moves in prices, and enormous price spikes and plunges. For instance, I could buy a barrel of Crude Oil on October 4th for $75 and then sell it in today’s trade for $94. That’s in just three weeks!

Why should you care? Because the Federal Reserve is viewing this short-term period of falling commodity prices (minus last month’s jump) as a green light to explore more easing. QE3 is most likely already in the cards. The Federal Open Market Committee (FOMC) has stated that inflation “appears to have moderated.”

Let’s put this into perspective:

 

This is a five-year chart of a basket of commodities. Notice that it is currently at the same level it was at when crude oil was trading at $150 per barrel in July 2008. Crude oil is now $94 per barrel, a full 37 percent below its high, and yet the index is at the same level meaning that the other commodities represented in the index have risen much higher. The slight drop that has occurred over the past few months is what the Fed is claiming as “inflation moderating.”

Let’s put this into further perspective:

 

This is a twenty-five year chart of the same index. Notice the huge run-up that began in 2003. This is when Alan Greenspan, under the direction of Ben Bernanke, lowered interest rates to 1 percent. It culminated in the summer of 2008 with gas prices hitting nearly $5-a-gallon, rice riots in Asia (the price of rice skyrocketed 135 percent in just six months in 2008) and food prices putting a major pinch on consumers the world over. Following the financial crisis, which finally put prices back into a conceivable range, Bernanke, now acting as Fed chairman, decided to boost prices for everything back up, far exceeding the levels seen at the height of the previous commodity bubble. They’ll go much higher if further Fed easing is implemented.

Look, even if Bernanke keeps inflation relatively contained while making unprecedented asset purchases and lowering interest rates in an environment of economic stress, the moment the economy picks-up and unemployment comes down, the nearly $2 trillion of reserves that banks are holding at the Fed will flood out into the economy and force prices much, much higher than anything we’ve experienced thus far. It will cripple the economy. The Fed claims to have the ability to combat this by raising interest rates and selling off their portfolio, but that too will crush any progress that an artificial recovery would have created. There’s no winning scenario that could possibly come out of this Fed’s policy.

In the Fed’s playbook you either have higher prices, or higher unemployment. The Fed has clearly chosen higher prices. Should its policy succeed and unemployment fall, a frail economy will emerge and present further problems down the road as propped-up business eventually fail.

In the real-world playbook we would be experiencing lower prices, albeit with higher unemployment, but those lower prices would allow proper allocation of resources and an economic restructuring that pulls resources (human capital and investment) away from a bloated financial and commodities sector and into the next great engine for growth. In the ‘80s and ‘90s that sector was information and technology. Our country experienced tremendous growth, rising standards of living, and rising wages. In the last decade of Fed intervention and Fed control our country has experienced the exact opposite: No growth, lower standards of living, and falling wages. Just look at the chart over the last twenty-five years, it speaks louder than words.


James Groth is Research Associate


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