The two-year upswing in commodity prices led many to fear a return to significant inflation that would engulf the overall economy. Most commodity prices, however, peaked earlier this year--copper and sugar prices topped out in February, cotton followed suit in March. Silver prices started their collapse in early May, as did crude oil.
Many commodity bulls see this as a short-lived price correction. I disagree, seeing it as a foreshadowing of further declines that will result from a hard economic landing in China, the world's biggest user of commodities. The reversal of commodity inflation would support my forecast of looming deflation, not serious inflation, in the years ahead.
When we talk about inflation or deflation, we usually mean what is measured by the consumer price index, producer price index, GDP deflator, or other measures of aggregate price movements. In my recent book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, I've identified seven varieties of inflation/deflation that need to be kept in mind as the arguments over inflation and deflation play out in the months and years to come.
Commodity Inflation/Deflation
The big run-up in commodity prices in 2009-2010 brought back memories of the 1970s' inflation spiral. In the late 1960s, the mushrooming costs of the Vietnam War and the Great Society programs in an already-robust economy created a tremendous gap between supply and demand in many areas. By the early 1970s, commodity prices started to leap and spawned a self-feeding upsurge. Worried that they'd run out of critical materials in a robust economy, producers started to double- and triple-order supplies to insure adequate inventories. That hyped demand, which squeezed supply, and prices spiked further. The spot commodity index rose 81% from November 1971 to October 1973, but then collapsed as all those double- and triple-ordered supplies arrived. The resulting inventory contraction made the 1973-1975 recession the then-deepest since the 1930s.
Greatly augmenting the most recent commodity bubble was the overlay of speculators and investors. Many pension and endowment funds, as well as individual investors, became convinced that commodities were a legitimate investment class along the lines of stocks and bonds, so they piled in and doubled their bets as prices soared.
Many investors were also impressed with the stockpiling of commodities in recent years by the Chinese, assuming that much more was in store. I believed then--in the midst of the bubble--and continue to forecast today that slow global growth lies ahead, especially as U.S. consumers continue to retrench in the weak economic recovery and slash the imports upon which most foreign countries continue to depend for growth, directly or indirectly. I look for a further nosedive in commodity prices as oversupply continues to swamp demand in a world of muted economic growth.
Wage-Price Inflation/Deflation
Wage-price inflation causes wages to push up prices, which then push up wages in a self-reinforcing cycle that can get deeply and stubbornly embedded in the economy. This, too, occurred in the 1970s. Back then, labor unions had considerable bargaining power. Furthermore, many business leaders felt they had a moral duty to keep their employees at least abreast of inflation, failing to realize that, as a result, inflation was very effectively transferring their profits to labor--and also to government, which taxed underdepreciation and inventory profits. The result was a collapse in corporate profits' share of national income and a comparable rise in the share going to employee compensation.
In response--and in the face of intense foreign competition--corporate leaders restructured as they recognized the globalized atmosphere of excess supply of almost everything. With operations and jobs moving to cheaper locations offshore and with the economy increasingly high-tech and service-oriented, union membership and power plummeted. The wage-price spiral peaked in the early 1980s as Consumer Price Index inflation began its three-decade-long downtrend.
Today, the wage-price spiral has been reversed. Contrary to most forecasters' expectations, wages are actually being cut and excess capacity in the labor market--amidst ongoing weak jobs growth and high unemployment rates--is sending real wages down.
Financial Asset Inflation/Deflation
Perhaps the best recent example of financial asset inflation was the dot com blow-off in the late 1990s, which capped the long secular bull market that started in 1982. Declining inflation rates in the 1980s and 1990s pushed down interest rates and pushed up Price/Earnings ratios. American business restructured and productivity leaped, starting in the 1990s. U.S. consumers embarked on a three-decade-long borrowing-and-spending binge that drove their saving rate from 12% to 1%, their borrowing rate from 65% to 135% of after-tax (disposable) income, and consumption spending from 62% of GDP to 71%. The secular bull market saw a P/E leap that jumped the S&P 500 at a 16.6% annual rate from the second quarter of 1982 through the first quarter of 2000.
Ultimately, however, the good times led to rampant speculation--especially in dot com and other new tech stocks, and then to the 2000–2002 collapse. But the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to commodities, foreign currencies, emerging market equities and debt, hedge funds, private equity, and especially to housing. The second leg down in the secular bear market I believe we are now in was, of course, triggered by the collapse of subprime mortgages and the financial crisis it spawned, starting in early 2007.
Since the early 1980s, then, we had a long bull market that gave way to financial inflation with the dot com blow-off. That was followed by two bouts of financial deflation as stocks declined by over 40% for only the fourth and fifth times since 1900. A financial inflation/deflation cycle has also occurred among financial institutions that greatly leveraged their balance sheets over the past three decades and are now being forced to raise capital, reduce risk, and cut their leverage.
Tangible Asset Inflation/Deflation
Booms and busts in tangible assets are a fourth form of inflation/deflation. The big inflation in commercial real estate in the 1980s was spurred by very beneficial tax law changes and by financial deregulation that allowed naïve savings and loans banks to make commercial real estate loans for the first time. But deflation set in later that decade, due to overbuilding and the 1986 tax law constrictions. Bad loans mounted and the S&L industry went bust.
Today, commercial real estate is again back in deflation. Ironically, it's not so much the problem of overbuilding shopping malls, office buildings, and warehouses in the past decade. In fact, the modest expansion, compared to the residential building bubble, encouraged many investors to bid up prices and to leverage commercial properties heavily. This left scheduled refinancing in trouble during the ongoing credit crunch. At the same time, the Great Recession pushed retail and office vacancies up. Property prices plummeted and delinquencies surged. Commercial real estate inflation and deflation has occurred repeatedly since World War II.
The staggering and ongoing house price deflation is the first since the 1900s. The housing boom was driven by ample loans and low interest rates, loose lending standards, securitization of mortgages, government programs encouraging home ownership and the conviction that house prices never decline. House price deflation actually started in early 2006 as the pool of unqualified buyers dwindled and the bubble began to collapse from its own weight. It gathered steam when subprime mortgage trouble leaped in early 2007. Then it jumped to prime mortgages as the recession and slumping stock market slashed the incomes and assets of those who really could afford to own houses.
Currency Inflation/Deflation
We all normally talk about currency devaluation or appreciation. This is, however, another type of inflation/deflation. Like all the others, it has widespread ramifications. Relative currency values are influenced by differing monetary and fiscal policies, CPI inflation/deflation rates, interest rates, economic growth rates, import and export markets, safe haven attractiveness, capital and financial investment opportunities, the carry trade, attractiveness as trading currencies, military strength or weakness, and government interventions and jawboning, among other factors. In recent years, Japan, South Korea and especially China have all acted to keep their currencies from rising to support their exports and limit imports.
For most people in the large U.S. economy, currency fluctuations are of little interest. They get paid, spend and invest in dollars. Imports and exports are relatively small pieces of GDP.
Even still, a weak dollar attracts foreign tourists while a strong buck discourages them. A cheap greenback may attract foreign investors but a declining dollar may portend more of the same and encourage them to take their money elsewhere. Many worry that China, with its large store of foreign currency reserves, mostly in dollars, will dump their greenbacks. But such action would no doubt precipitate a dollar collapse and global depression that would slaughter the exports on which China depends for growth, to say nothing of collapsing the value of its remaining dollar holdings.
The dollar has been weak in recent years, but I'm bullish on the buck, seeing it as the eventual global safe haven in a weak and possibly recessionary global economy.
Inflation by Fiat
Back in 1977, I developed this sixth concept to encompass all of the ways by which, with the stroke of a pen, Congress, the President and regulators raise prices. Increases in the minimum wage, as occurred two years ago, are a case in point. So, too, is the imposition of higher tariffs on imports. Agricultural price supports keep prices about at equilibrium. Federal contractors are required to pay union wages, which almost always exceed nonunion pay. Environmental protection regulations may improve the climate, but they increase costs that tend to be passed on in higher prices. Pay hikes for government workers must be paid in higher taxes sooner or later.
Back in the late 1970s, we calculated that inflation by fiat added 2% to the CPI. There was some deflation by fiat in the 1980s and 1990s, namely the federal welfare overhaul that required recipients to work or be in job training programs.
Now, in reaction to the financial collapse, Wall Street misdeeds and the worst recession since the 1930s, substantial increases in government regulation and involvement in the economy are assured--and with that, more inflation by fiat.
Standard Inflation/Deflation
The seventh variety of inflation/deflation is the standard inflation/deflation type caused by a substantial gap between aggregated supply and demand. Excess demand resulting from heavy spending and the Vietnam War and Great Society programs spawned that sort of inflation in the 1970s, as noted earlier. Commodity inflation preceded it and the wage-price spiral was part of the whole inflationary climate back then.
This inflation type is highly unlikely today with the commodity bubble collapsing, high unemployment and with deleveraging suppressing private demand--despite huge monetary and fiscal stimuli. Since early 2006, government borrowing has jumped from 3% of GDP to 11.5%, but that has offset only half of the drop in private borrowing, from 16% of GDP to -0.5%.
Five of the Seven Deflation Types Are In Place Today
Cuts in wages and hours worked are being used to reduce labor costs in addition to layoffs (wage-price deflation). Commodity prices are falling (commodity deflation). Commercial real estate deflation continues, and excess inventories threaten another 20% decline in house prices (tangible asset deflation). Stocks are again falling (financial asset deflation). And the dollar as well as Treasurys may be reasserting their traditional roles of safe havens (foreign currency deflation).
The least accepted variety of deflation remains general price declines. If I am right and the CPI and PPI fall chronically by 2% to 3% per year, it will be a big shock to almost everyone else who expects the opposite. Unlike general inflation, which is generally considered undesirable, deflation comes in two flavors: the good deflation of excess supply and the bad deflation of deficient demand. We're probably facing a combination of both.
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