Inflation, that retro economic scourge of the 1970s, has embarked on a bit of a comeback tour. While core inflation figures remain low in the U.S., the consumer price index (which includes food and energy) rose the most in 17 years in 2007, jumping to 4.1% from 2.5%. That lends credence to the warning by a group of economists that the road ahead will be marked by good old-fashioned ’70s-style cost-of-living increases once the current downturn is done.
It’s been a generation since general increases in annual prices were a part of the national conversation. But back in 1979, when inflation hit double digits and drove the purchasing power of $100 down to just $87 in a year, it was a major concern. Middle-class citizens fretted about the clear and present danger to their standard of living, and policy-makers worried western societies were going to be gutted economically. But Armageddon never arrived. Inflation relaxed through the early ’80s and eventually faded as an issue in the ’90s — the result of a combination of factors, according to Donald Coxe, global portfolio strategist of BMO Financial Group. The mining and oil boom during the ’70s brought a flood of energy, metals and food onto world markets; Ronald Reagan tamed the unions; and there was plenty of low-priced goods manufactured offshore coming into the West. All of which put a cap on price increases and ushered in a 25-year golden age of low and stable prices that has stretched almost to the present day.
The problem now, though, says Coxe, is that this era of disinflation is coming to an end. In a new report, Commodities After the End of Deflation, Coxe updates the prescient call he made five years ago about the beginning of the commodity bull market that has dominated this decade. Resource investors will be glad to know he still thinks the current bull has another five years to run, but now that run will be in an inflationary environment, rather than a deflationary one.
A recent trip to India convinced Coxe that 25 years of global trade has allowed many of the world’s formerly poor to increase their consumption of food and energy and take on a more western lifestyle. A global boom in protein consumption means more grain is fed to animals to manufacture meat, causing a structural change in the demand for those food grains. “The burgeoning Chinese middle and upper classes’ demand for meat and dairy products means that growth in China’s consumption of feed grains is much faster than its famously growing demand for oil and metals,” reports Coxe.
The result is that global grain prices are rising even though the world has just experienced two bumper crops, something that hasn’t happened since the Second World War. (Canadian Wheat Board shipments through Churchill, Man., hit a 30-year high this year, the highest amount of grain since 1977.) The result? There were food riots last year in Yemen, China and Mexico, while all-in inflation has been running ahead of core inflation (a measure of inflation that doesn’t factor in food and energy) in North America for some time. And while food may not make up much of the average western household budget, the larger worry is that the globalized trade networks set up over the past 20 years have also begun to pass along inflation. “The ability of China and India to continue to export deflation is being weakened by the high percentage of foods in their CPIs (consumer price indexes),” says Coxe.
There’s also a global boom in biofuel production. “The supply in relation to consumption is at an all-time low in terms of grain. And now corn for ethanol is crowding out other crops, and so you have a situation where you have even more limited land for wheat and rice and whatever,” says Coxe. “In an environment that is already very tight, that’s a recipe for increased food prices, food inflation.”
U.S. food inflation is already running at 4.9% in the consumer price index, the highest since 1990. But Avery Shenfeld, an economist at CIBC World Markets expects that to go even higher. “By the end of [2008], we predict that food inflation will be running well over 5%, and as ethanol production rises to nine billion gallons in 2009, food inflation will rise to 7%, its highest level in more than 25 years,” he says.
This story is about more than food prices, however. Demographic trends, such as the reduction in the birth rate that kicked in around 1970, will continue to constrict labour supplies and also contribute to inflation. And rising energy prices also have to be considered. Everyone is certainly aware of the current high price of gasoline, which could be up to $1.50 a litre by the spring, but what about the price of natural gas, which heats many Canadian homes? They may be too low right now for Alberta’s drillers to be at full capacity (a result of both high storage levels and the decreasing profitability of opportunities in the declining Western Canadian Sedimentary Basin). But those supplies will eventually get worked through, says Benjamin Tal, senior economist with CIBC World Markets. “Right now, natural gas prices are extremely cheap compared to oil,” says Tal. “Historically, they don’t stay cheap for too long.” That’s because industrial users start switching to gas from oil to cut costs.
Anti-global-warming policies will also increasingly come into play in the years ahead. For example, Ontario is phasing out its coal, so 50% of its new electricity is coming from natural gas. “Natural gas has been the beneficiary of the move away from coal, and that’s again a structural thing that I think will have an impact on inflation,” says Tal.
Taken together, the strange entanglement of macro forces — rising living standards across the developing world, new biofuel production, depleting traditional energy sources and attempts to cut greenhouse-gas emissions — suggests the world has become inflation prone in a way it hasn’t been in a generation, says Coxe. “It won’t be as bad as the ’70s,” he assures. “But there is a real worry we could see over the next couple years the most painful global inflation we’ve seen in three decades.”
No less an authority than Alan Greenspan, former Fed chair, has suggested as much. In his recent book, The Age of Turbulence, he states his replacement, Ben Bernanke, will have a tougher job than he did. Poor Bernanke will have to manage through an era in which rising living standards around the world will lead to real inflation, volatility and economic instability, and possibly, according to Greenspan, double-digit inflation.
Of course, not everyone agrees. David Wolf, head of Canadian economics and chief strategist with Merrill Lynch Canada, agrees prices will have to rise over the long-term as a result of increasing living standards in the rest of the world. He’s just not convinced about the timing, suggesting we’ve got a way to go yet before we’re affected by Chinese-exported inflation. He argues that Chinese producers will focus on maximizing employment and output rather than profits, and will make the necessary price cuts to maintain their market share if exports start to decline. He also points to the appreciating Canadian dollar, which is putting downward pressure on goods prices in Canada, as another key reason why we won’t see a big return of inflation.
But others are talking about the possibility of something even worse than inflation: an economic environment in which a recession deepens, or stagnates, at the same time inflation keeps rising. Back in the ’70s, they called it stagflation. If that’s the case, Bernanke is going to have a really tough go of it, especially since the sub-prime meltdown has forced the Fed into more rate cuts to maintain “liquidity” and keep the banking sector from dissolving.
Oddly enough, that change in focus will add to the problem ahead. Some suggest that M3 U.S. money supply — a broad measure of the total of money outstanding (no longer calculated by the Fed, much to the consternation of conspiracy theorists everywhere) — is expanding at its most rapid rate ever. And that has to be taken into account by inflation watchers. “There is too much of the ’70s to ignore here,” says Coxe. “Now we’ve got banks like the Fed forced to print more money to try to restore liquidity at a time we’ve got the money supply growing faster than the production of goods and services, which, by the way, is the technical definition of inflation.”
Worse yet, the Chinas and Indias of the world are cranking up the money-printing presses to keep their currencies from rising too fast against the U.S. dollar. “Russia, the world’s seventh-largest economy, is realizing monetary supply growth of over 40% now,” says Coxe. “Anybody who thinks inflation is still going to be measured between one and three percent 12 months from now isn’t reading the story. This is going to become an inflation reality show.”
