February 23, 2011
To our dear friends and clients,
We had recently published our first article on Inflation as I felt this would be or become topic that would impact both lives of investors and also their portfolios. Given the price increased in commodities I felt that there would be underlying inflationary pressures that would impact our lives. This has so far not occurred to a great extend. I subsequently analysed what is called the Produced Price Index. The Producer Price Index is a wholesale price index, the cost that producers pay for their goods and services. The Producer Price Index is sub-categorized in various groups, Industrial, Raw Material and Services. Some of these show a different story which will lead into our next article and offer a further insight why inflation is a threat we will have to deal with in the near future. In this article Bernd, my partner, has been able to connect Economics 101 to the real world in this article in a very congruent and understandable manner in examining the Consumer Price Index, the price index that affects our daily lives.
Inflation: What causes it?
Last time we examined the calculation of the Consumer Price Index (CPI) and how it applies to the average Canadian household, but not necessarily to you. Now, we want to look more in detail what can cause it and how do the economic relationships work. You will say it is easy to determine what causes inflation, e.g. higher commodity prices, higher import prices, higher wages.
Yes, these are obvious items that have an effect and we will get back to it later. From a monetary economic point of view an important variable is money supply and how it is connected to other aggregate economic numbers. The quantity theory of money provides such a frame work, it looks at the relationship between the velocity (V), the money supply (M), the price level (P), and the output (Y). This is represented by the equation M * V = P * Y. The right part of the formula represents the nominal GDP (P * Y).
How does this help me in estimating inflation? Assuming that the velocity and output are constant a 3% increase in money supply would result in a 3% price increase. Is it really that easy? No, let’s take the US as an example. The money supply measured by the money aggregate M2 increased from end of 2007 to 2010 by 18.66%.
However, up to this moment this has not yet translated into higher prices as prescribed by the theory, as the price level increased only by 4.35% in the same time and the output was constant. Why, the velocity of money went down by 11.36%, as every solvent bank was sitting pretty, hoarding cash, cutting credit lines and therefore not increasing the circulation of money. In addition the consumer was suddenly concerned with their debt levels and started saving and paying down debt. Velocity can also be considered as an indicator of business activity, if consumers and businesses buy goods – money changes hands. The more active the economy, the more often money changes hand or is created through use of credit. This is why central banks across the world, especially the FED, have stepped in and pumped money into the economy and become true lender of last resort. This was good news during the recession, but what if the economic activity increases and the velocity starts to rise again. If the central banks cannot reduce the money supply this will end in higher inflation.
An additional point of view is to not only consider the monetary policy of a country but also at the fiscal policy. In recent years the fiscal theory of the price level, a new economic theory is quoted more frequently. It states that government fiscal policy can affect the current price level, by connecting the present value of future government tax and spending plans to today’s outstanding government liabilities through the inflation rate. For example, if it is expected that the government is spending more money in the future, than a higher inflation rate is necessary to off set this and create the same present value of all future spending plans. (Note: A higher inflation rate results in a lower present value of future cash flows.)
This causality has been shown in the past, however the effect on the inflation rate is not always as direct as expected and is highly dependent on the expectations if future governments can produce a balanced budget or even a surplus. Otherwise, we would be in deep trouble, given the current fiscal deficits in the developed world and future obligations due to an aging population.
We looked at the monetary and fiscal policy influence on inflation and its danger. What are other factors that impact inflation such as higher commodity prices? These factors will eventually be passed on to the consumer, if they are perceived to be permanent by the producer. Bad weather for example that affects the harvest in one region might not result in a direct overall price increase. But an increased demand or decreased supply due to permanently altered patterns will lead to higher prices. The recent uproars in the Middle East are partly attributed to higher food prices.
At the same time developed countries phase the danger of imported inflation because several emerging countries like Brazil, India, Indonesia or even China experience higher inflation due to the fact that their economies have expanded at a higher rate than they increased their capacity. As these countries manufacture many parts for industrialized countries, price increases are passed on; for example import prices in Germany increased by 12% in the last year.
From a Canadian perspective we are somewhat sheltered from this effect up to this point as the Canadian Dollar has appreciated against most other currencies and this absorbed some of the price increases; on the other hand it reduces our competitiveness as our goods become either more expensive for foreigners to buy or our companies earn less money on it.
Another big influencing factor on inflation are increases in wage levels. In recent years wages in developed countries have been stable or have even declined. As the economy will pick up, we will see that people will ask for higher salaries. Currently, the main argument against this is that the unemployment rate is too high and therefore employees and unions don’t have the negotiation power to demand higher wages. This argument might have some validity for unskilled work, but in professions where skilled labour is needed and cannot be replaced by a random unemployed person, employees will start to push for higher wages. These factors are already apparent in the Producer Price Index.
All these factors raise concern, so watch out for inflation, but don’t expect that it will materialize in one big jump. However why worry about inflation other than more expensive goods. It will also impact interest rates and therefore mortgage rates. Several recent articles have already stated that the average consumer debt level is higher than ever before since it has been measured at more than 145% of income. Can all the consumers that have purchased expensive homes continue to afford their mortgages if mortgage rates increase by 2%. This would represent almost a 50% increase on a 5 year mortgage. What will happen when these come up for renewal ?
As always, should you wish to discuss this further or would like us to review your portfolio please call us at 416.572.2265 or email us.
Bernd Henseler Albrecht Weller