What Will Tomorrow Bring: Inflation

The US Fed cut rates last week, citing the recessionary risks of credit losses stemming from mortgage/ARM losses. They seem to have fallen off the wagon. Nearly three decades of global economic stability have depended on US economic stability. And that has depended on the principle of low inflation. Below I'll look at positive AND negative pressures on the price level. The net qualitative assessment of my (admittedly quasi-scientific) analysis is that inflation will increase in the next 12 months. The message is that it's a good time to hedge against inflation.

The price inflation data is just getting less and less deniable. I put forth the following observations:

• The housing price increase is a bubble .... and that bubble will break. However, the bubble masks some degree of real (and permanent) price inflation. Thus, even as the bubble is "deflated" prices are very unlikely to drop back below historic lows for any significant period of time. In fact, they are likely not to return even to historic averages. This is a global effect.
• Recent articles have begun to raise evidence that, from mortgage costs to rental costs to maintenance and taxes there is a significant and lasting increase. BLS puts this above 4% for the 12 months to 7/2007
• Energy prices are, of course, at the forefront over many peoples' minds, and with good reason. BLS puts energy-inflation at 21% for this year (seasonally adjusted). Petro-inflation has approached 40%. Again, the impact is global on the consumption side. An interesting add-on effect further exacerbating the inflation problem is this: oil exporting countries are awash with so-called petro-dollars and are buying up everything in sight ... at any price, since that is way down their list of priorities.
• Medical costs (to the consumer) are running at 6%. Managed healthcare has placed downward pressure on medical costs, both via pressure on providers to reduce rates, as well as by ourtright refusal to pay for certain treatments, but the net effect is in favor of increased prices.
• Our current weak-dollar policy will increasingly encourage foreign purchases of (greater quantities of) US goods as they become relatively cheap in comparison to other global alternatives. This increased foreign demand will push up the price of these goods ... and also the price (exchange rate) of the Dollar. The global impact of this is less clear. The US's price increase may have offsetting effects in countries which compete with us to export goods.
• The growing wealth and mobility of billions in the third world is largely stashed into savings. However, the long term influence on global price levels cannot be denied. It may well balloon into the biggest factor in price calculations someday soon.
• Smaller anecdotal observations include:
  • Increase in private jet travel over scheduled service
  • Luxury goods inflation is running at 6%

The devil's defense counsel might retort with the following DEflationary pressures:

• House price decline leads to lower consumer confidence and fewer home-equity loans
• Increased mortgage interest rates lead fewer people to borrow, thus de-leveraging the economy and
• Innovation-driven decreases in prices, especially for electronics. While this initially requires big spending (thus an influence for +inflation in the short to medium term) it eventually leading to better, cheaper, more mass-produced, and eventually commoditized products (thus pushing for -inflation in the medium to long term). This is vividly on display in the BLS CPI reports, which have consistently reported declines in computer prices of late. Their current number for 2007 is -12%.
  • BUT ... the increase in the speed of obsolescence of most goods forces consumers to replace their goods (especially electronics) more frequently, increasing spending (as well as monetary velocity). On the corporate level, the focus is on the increased depreciation rates. This causes the PV of purchases to decrease and the net tax liability (ceterus paribus) to decrease, leaving additional funds for futher investment.
• Similar effects are attributed to increased productivity

Outside the pure "price" picture, of course the second major component of the overall inflation equation is the interest rate. This factor, at different time horizons, has different (even contradicting) effects on economic growth, as well as price inflation. For example:

• CD, money market, and other deposit interest rates are being bid up as various lenders look for additional funds to back-fill their balance sheets as their loan write-offs bloom. Please, someone, remind these guys of the S&L debacle of the early nineties.
• The Fed's rate cut has a multitude of effects. I'm currently reading Greenspan's book in which he professes not to fully understand all the ramifications. Among the clear ones, however:
  • Short-term, credit card interest rates go down, encouraging consumers to increase spending
  • Short-term, banks can grant loans at lower rates as they pass the lower interbank borrowing rates along to their customers.
  • To the extent banks get away with NOT passing these along, assuming their transaction volumes do not decrease, their earnings increase.
  • Longer-term, as both banks and companies post higher earnings:
    • They are able to invest more, a growth (and inflation) increaser
      • however, there is a a law of diminishing returns when it comes to the marginal dollar invested
    • Their stock prices increase, thus increasing the wealth of investors, who in turn may increase spending based on their self-assessment of long term net worth

Further Reading:
THE source: http://www.bls.gov/cpi/cpid0707.pdf
http://www.reuters.com/article/domesticNews/idUSL2424052620070924?feedType=RSS&feedName=domesticNews&rpc=22&sp=true