Farmers harvesting inflation?

In the blog "The Great Norwegian Depression?", I said that the markets no longer worry about inflation. And how can they? Aggregate demand is down in all countries, energy prices are falling, people are losing jobs and the level of savings is reaching new highs. In fact, senior portfolio manager at Storebrand Kapitalforvaltning, Olav Chen, says that "nobody fears inflation now" and follows up by saying "most of us worry about deflation" today on e24. So, everyone should be concerned with deflation. Well, I'll explain now why calling off inflation may be a dangerous move.

The fall in the prices from September to October in consumer prices hit a record 1% in the US. Energy prices fell an even more astonishing 8.6%. This is still an increase of 3.7% from the same period last year.

First off, some comments about inflation. Inflation is the general increase in prices over time (usually a basket of common goods is used to measure the CPI. The changes in the CPI is the inflation. Other measures are used such as The Economist's Big Mac Index). There are four main factors that lead to inflation: (1) the supply of money goes up, (2) the supply of goods goes down, (3) demand for money goes down and (4) demand for goods goes up. I'll refrain from taking the lecturer's hat on and leave it up to the readers to go into detail about Keynesian Economics (cost-push and demand-pull inflation). But let's delve more into the inflation factors.

In recent years (2003-2008) most countries have had relatively normal inflation levels. This is odd, since all of the 4 above mentioned factors were in place, right? Yes and no. Due to the immense capacity for growth in the BRIC countries (Brazil, Russia, India and China), countries have been "importing" low inflation for years. So although wages were rising in booming economies, production costs' reductions compensated for that increase (by moving production/support services/maintenance to BRIC) thus leaving prices for the final product relatively stable (the exceptions were of course oil, gold, platinum and quite a few other commodities).

Today, the situation seems to be the complete opposite with the fall in demand having to take most of the responsibility (why investors are more worried about deflation than with inflation). We are in a recession there is no doubt about that (at least in my head). In order to understand more what will happen to inflation let's first take the worst case scenario i.e. that we are in a recession (ideal for deflation). If households and companies stop consuming and investing, and instead hold cash, then we would expect deflation. However, history tells us that in a boom we have inflation, but in a recession we don't have deflation. During one of the worst recessions in the US since WWII, real GDP fell by 4.9% (between November 1973 and March 1975), but the inflation in that same period was 14.68%!

Why is that the case? If deflation is the opposite of inflation, then one would expect deflation in a recession and an inflation when the economy is booming? There are two reasons why deflation is not as frequent as inflation. First of all, wages are sticky downwards. That means that as soon as GDP rises, wages rise. But, when the economy slows down companies usually lay off workers (which takes time) instead of cutting wages ("Protectionism in Action" signed by trade unions). However, eventually this effect is not enough to avoid deflation. It is the second effect that ensures that the economy seldomly experiences deflation: namely the increase in money supply.

During that recession in 1973 to 1975, the seasonally adjusted M3 (money supply) rose by 24.4%. Historically, regardless of the financial climate, central banks have been busy feeding the markets with capital. And since most central banks don't seem to have forgotten the old trade of chipping in a dime every now and again (take the joint US/Euro-zone rescue package just a few weeks ago for instance) we won't have a problem with deflation. In fact, as shown by the previous historical example, inflation is what we should be concerned with especially in these times of high injections of capital to the markets. Now, what if central banks "run out" of money and are unable or unwilling to keep supplying the markets with cash? That is a question we'll have an answer to in a few years (then inflation will probably be the least of our worries).

Inflation is looming due to the high supply of capital. Now what about other effects? Hint: I mentioned farmers in the heading of this blog, but I still haven't said anything about farmers yet. A case of just being forgetful?

History can only tell us so much. Most economists, investors, governments, business leaders, housewives, carpenters (I'll stop now), etc will agree that the current situation is a rare one and thus needs to be scrutinized further than just being compared with similar, past events.

Here's the situation that is spinning around in my head and will make the case of deflation seem even more distant. Please, bear with me on this. What does every human being need? Food. Who makes food? Farmers. But what is happening to the farmers around the globe? Firstly, they're experiencing droughts and hurricanes of larger magnitude and a higher frequency than ever before. Australia is battling its problems with drought (desert is expanding), the US faces problems with hurricanes and ruined soil for its cattle, hog and corn production. BRIC are turning their best areas for farmers into highways and new office buildings in order to attract foreign capital. This leaves production at a plateau despite increased demand as the population is growing and thus leads to higher prices. Secondly, in order to increase production, farmers need to produce more on the same area of soil. The solution? Buy fertilizer! This is where I believe the problem will initiate.

Farmers are not as financially strong as large corporations to tackle increases in costs and new investments. Therefore they'll have to borrow money in order to buy fertilizer (think of the fertilizer being an investment since the increased harvest comes in the future). Due to the financial crisis and the tightened grip around lending practises, many farmers will struggle to get their loans and thus be unable to afford even the minimum investment in fertilizers needed to increase production. As a result, the prices for commodities will increase. Mainly for commodities from countries which have an unstable climate and many small farmers (the US has huge farmers compared to Argentinian farmers who are plentier, but smaller).

In addition, the actual inflation is obviously important, but so is the expected inflation. The reason being that households and companies will alter their consumption and investments decisions based on the expected future inflation rate as found by the Federal Reserve Bank of Cleveland. Thus, I believe we may even have a case of stockpiling. The production can't be maintained so buyers of rice, cocoa, beans, corn, etc will expect prices to rise in the future. They will fill their inventories with commodities (since they expect rising prices). As a result, prices rise even more and farmers will have to pay more for fertilizer as the demand for it goes up, leaving them no better off than initially. Thus, central bankers should be concerned with expected inflation and moderate interest rates accordingly. This is obviously not the case as interest levels are going down across all continents to stimulate growth.

If this ends up being "the perfect inflation-storm" is yet to be seen, but if that occurs then we may even have hyper-inflation in some parts of the world. In Zimbabwe, hyper-inflation is ruining the economy. Steve H. Hanke, a professor at The John Hopkins University and a Senior Fellow at The Cato Institute, has measured the hyperinflation in Zimbabwe and named the indicator Hanke Hyperinflation Index for Zimbabwe (HHIZ). The indicator starts in January of 2007 with an inflation of 13.7%, which is high, but no where near the levels we are seeing today.
In fact the annual inflation rate is a staggering 89,700,000,000,000,000,000,000%, which means that prices are doubling every 1.3 days. Eventually the inflation level becomec irrelevant as the econoomy stops functioning. What is causing this hyper-inflation? Obviously, Mugabe's Zimbabwe is a special case, but it boils down to that goods are in short supply.

Some will argue that although deflation is rare, that's exactly what we are seeing now! Prices fell from September to October. Although energy prices are down and probably will fall even more before they stabilize, the CPI (excluding energy) will also fall in November and December. This has a very simple explanation. In order to attract shoppers to their stores, Christmas shopping discounts and generally lower priced products and services will be common this season and ensure that prices will fall until January. That's when our inflation will pick up. Some time during the first half of 2009, inflation will again be in the limelight.

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This blog is intended for the interest of the readers only and the blogger bears no liability as a result of investments undertaken from advice given in this blog. I have used citations that are accurate to the best of my knowledge, information that is correct and I apologize in advance for any spelling errors.