Commodities | Jul 11 2012
By Greg Peel
Inflation, disinflation, deflation. Let's get some definitions out of the way. “Inflation” is when prices rise and “deflation” is when prices fall. “Disinflation” is when prices rise but at a slowing rate. Think of it as inflation as the accelerator pedal, disinflation as the brake and deflation as reverse gear.
Here are some more: “stagflation” occurs when inflation rises but GDP slows (usually inflation implies economic growth); an “inflationary spiral” occurs when prices rise, so wages rise, so prices rise again and so on; and “hyperinflation”is inflation gone mad, such as Zimbabwe last decade or Germany post World War I.
Gold, as we have come to appreciate over the post-GFC years, suffers from a multiple personality disorder, such that while it is traditionally a hedge against inflation and a safe haven it often trades like a risk asset on occasion. Such “risk off” behaviour has been evident rather frequently these past few months. Gold has seen its first decent correction this year of its decade-long bull run. However, we can match up that bull run quite clearly to global monetary easing (zero interest rates, QE etc), suggesting at the end of the day, gold is still a hedge against inflation.
The post-GFC years have seen widespread “deleveraging” across businesses and households. Reduction in credit balances and in credit demand is a disinflationary force, as is the newfound austerity drive undertaken by average consumers across the Western world (not just in Europe). Witness Australia's retail sector and all those “75% off!” sales. That's disinflation.
If we turn to the US, we note the following graph of headline consumer price (CPI) inflation as the red line, and the Fed's core inflation (removing volatile food and energy prices) as the blue line. It's all very well to remove such “volatile” items for smooth monetary policy purposes, but for businesses and households the costs of energy and food are a substantial proportion of budgets.
The graph shows that US inflation spiked up in 2008 (oil hit US$147/bbl) before collapsing along with Lehman Bros. Rapid disinflation took us all the way into deflation until the Fed unleashed the first of its QE programs. Greece was the trigger for the next disinflationary period after which came QE2, and the recent disinflationary trend is why there's plenty of talk of QE3.
CPI is only one measure of inflation. There are frequent claims, notes Adrian Douglas of Market Force Analysis, that the US economy has entered a period of actual deflation. With US debt levels ever increasing, banks, companies and consumers hoarding cash, and the threat of an upcoming “fiscal cliff” of simultaneously spending cuts and tax increases, it's not any easy argument to dismiss. However Adrian Douglas suggests “These [deflation] claims are totally unfounded and are false”.
To support his argument, Douglas cites the following graph:
The Continuous Commodities Index (CCI) differs from the CPI in that it tracks only wholesale costs of raw materials rather than retail level costs of products, and does not include other CPI elements such as service costs, rent etc. The CCI's constituents are cocoa, coffee, corn, cotton, crude oil, gold, heating oil, live cattle, live hogs, natural gas, orange juice, platinum, silver, soybeans, sugar and wheat. The index is calculated as a geometric mean and not an arithmetic mean, meaning, for example all prices must rise 10% for the index to rise 10% or one price must rise alone by 500% for the index to rise 10%.
Two points we note about the make-up of the index is that it's heavily weighted towards food and energy, rendering it vastly different from the Fed's core CPI, and that it contains gold, which if we're talking about inflation hedges is somewhat of a double-count. The other thing we notice is that compared to the CPI chart above, the CCI has been trending upward for the past decade.
“The financial crisis has caused a massive increase in money supply coined 'quantitative easing',” Douglas notes. “This has led to relatively more money chasing fewer goods and services: a textbook definition of inflation”. The US has also been fighting two costly wars over the past decade but instead of “exercising fiscal discipline” as a result, “money has been printed at an alarming rate”.
Douglas suggests there has been no true occurrence of “deflation” globally in the last 77 years. Japan since 1990 is often used as an example of deflation but given Japan's money supply has never actually contracted – only slowed occasionally to zero – Japan has realistically only suffered disinflation.
Douglas points out that the CCI has recently turned upward once more, as the graph shows [even before QE3 is implemented]. If Japan is usually cited as the pin-up for deflation, Weimar Germany is the pin-up for hyperinflation. Warnings of impending US hyperinflation have abounded since QE1 but have to date proven at least premature if not erroneous, with credit deflation cited as the counter-force. Douglas suggests, nevertheless, that “The parallels of the US economy with that of Weimar Germany are eerie”. Germany printed money after WWI to pay its war reparations and to counter what was seen as a deflationary threat. Deflation never eventuated but rather Germany descended into hyperinflation and the destruction of wealth.
The hyperinflation argument was seen post-GFC as the reason to buy gold (and silver). It's been a worthy call so far even without the hyperinflation, but recent price behaviour has gold bulls concerned the rally has finally stalled.
Douglas suggests otherwise, and recommends buying precious metals.
Technical limitations
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