Sic Semper Tyrannis

Now that commodities inflation is undeniable -- it is hard to ignore pan-global food riots -- there is naturally a great deal of bickering over the cause.

This "ag-flation" surely must agitate many on Planet Wall Street, since they had decided by the beginning of the decade that inflation was dead forever -- vanquished by the "enlightened" Fed and its legion of obedient clones worldwide.

If you ask Ben Bernanke where the inflation is coming from, he'll point to anything other than the Fed itself. Roaring global demand is a popular excuse. A more mysterious answer the man invokes often is "inflation expectations". Whatever the excuse, The Fed doesn't like the damned stuff, which is why they (and other government bureaus) work so hard at stripping any trace of it from their key "inflation metrics" (CPI, core-CPI, PCE, GDP deflator and friends).

But there are big problems with each of Bernanke's excuses.

Follow up:

Let's tackle the latter first: Bernanke and his legions of well-trained University economist-bureaucrats never explain how the masses suddenly acquire the expectation of inflation after enjoying negligible levels of it for so long. This may be a glaring indicator that rising energy prices, food prices, and health care prices are being noticed by regular people even if the Fed ignores them. Is that tipping off the dreaded "inflation expectations" and a self-reinforcing spiral of inflation?

In other words, inflation would be causing inflation expectations -- not the other way around (for those keeping score at home).

Even if the Fed conceded this, they would undoubtedly fall back on their claim that this sort of inflation has more to do with low supply or high demand than anything the Fed controls, so is certainly not their fault. (You can almost hear Bernanke breathing a sigh of relief).

But there's a problem with that argument too: how can all these goods and services be bid up in price without someone supplying the money to back up those bids?

The logic here is simple: if the money supply is constant, society can only spend a fixed amount per year on goods and services (assuming the savings rate is constant -- which in the case of the US is conveniently zero and has been near that level for quite a few years). Sure, prices in one market can go up, but prices somewhere else will ultimately have to come down as a consequence. You cannot spend more on energy and keep buying steaks -- you have to switch to hamburger. Or stop eating out. (Or cut into your savings, if you had any. But even savings relies on asset markets with prices of their own -- see below).

So how is the world collectively bidding up all these commodities?

The conclusion is clear: someone must be creating all that money (or money substitutes). Or someone is allowing it to be created.

Or someone already created it... over a period of decades.

In reality it is a mix of all of these: money substitutes (credit of various forms) are being created like gangbusters -- these show up in the broader money aggregates like M3 (no longer officially reported by the Fed) and in the astronomical levels of derivatives and rate of their creation (likely on or around $600 trillion since last reported by the BIS).

One must also understand that the Fed spends most of its time expanding the base money supply to "grease the wheels of the economy". The typical growth rate of M1 is 3-5% per year. Why then hasn't inflation been a smooth 3-5% over the past couple decades? (At least, not as measured by the CPI).

Let's assume this is truly the case (the government statistics are what they seem). It follows then that base money supply growth was not showing up in the prevailing consumer prices metrics. How can that be?

The key observation is that money supply increases may not show up price-based inflation metrics as long as it they are focused mainly on areas not counted by these metrics. In specific, most financial asset markets are not measured by consumer price metrics and are thus a convenient place to hide from them, effectively "storing" money creation. Stocks, bonds, structured finance, and even houses (home prices were conveniently removed from the CPI in 1983) would be included.

So all that created money and credit (especially since the mid-90s) went somewhere -- not base money supply or consumer prices, but instead, financial asset markets.

Suddenly it seems that jig is up: the financial economy has now been hit by a massive earthquake in the form of the credit crunch -- the near total collapse of structured finance. Has all that money and credit simply been destroyed?

Some of it certainly has. But quite a bit of it has simply fled from these markets for greener pastures.

This is evidenced by the fact that the collapse of exotic asset prices (such as the ABX asset backed security indicies) seems to far outpace the level of write-offs that have actually taken place to date on these securities and assets. Many observers have commented on this in puzzlement. The SEC has even ruled that financial companies can take a holiday from valuing financial assets according to their readily-available market prices, as long as those markets are deemed "distressed". While a ruling like this is ripe for abuse, there is some truth to it, as many assets are likely being valued below their intrinsic long-run worth.

At any rate, this is the modern version of a "run on the bank" -- a run on structured finance!

Not lost on the proprietors of much of this "hot money" is the fact that commodities had already been trending up, and that there are many new ETF-based vehicles available to invest in them. So the "spill out" of structured finance spills into commodities.

So then what triggered the commodity price rise initially? Many factors, but undergirding all is probably the fact that all central banks around the world had been copying the Fed and continually expanding their money supplies in concert. This is especially the case for China, which has been one of the main drivers of global "demand". That demand was fuelled by accommodative monetary policy, pegging to the dollar, and the instigation of a central government that saw rapid middle-class-ization as the best way out of backwater Communism.

Certainly, China and India and other developing countries should be able to modernize and join the first world, but there is no reason to do this at such a reckless pace.

At any rate, the point is the inflation genie has been let out of the bottle: unless Draconian measures are implemented to mop up all that money/credit created over recent decades, it will spill into the most attractive markets. That is, something somewhere will always be bid up to protect the wealth of anyone who has any worth protecting. And since governments do not have perfect control, such "mopping up" is likely to prove impossible.

Even scarier is the possibility that by muffling price signals (the symptom) and not allowing markets to reconcile supply and demand naturally, dangerous resource shortages may become endemic.

Adding to the hazard, artifically low interest rates in the US and other Western countries (to bail out ailing housing markets and banks) combined with high inflation creates a situation of "negative real interest rates". That means, relative to the price level in general and especially rising markets like commodities, you get paid to borrow and speculate. At least, if you are privileged enough to have access to these low fiat rates. This does not help matters at all: it automatically makes commodities dramatically more attractive than financial assets.

So it is a fine mess these central bankers have created, all stemming from their ridiculous philosophy of "money supply and credit do not matter". All the while, the consequences continually pop up everywhere they are not yet looking and wreak havoc.

The Fed seems cognizant of some of this -- they have not increased the monetary base in ages, and are implementing all manner of parlor tricks (TAF, TSLF, TSLF) to bail out banks while not increasing that base money supply.

But it is too late -- stopping now just won't help. As we established, there's too much money out there already, and even worse, the money supply is still increasing dramatically (exponentially) in most other countries -- especially those who implement measures to prop up the dollar against their local currencies (this causes inevitable money-printing in those currencies).

Curiously, you hear nary a peep out of Bernanke saying the "dollar pegging to support US borrowing must end" -- for that would worsen short-term inflation in the US and make borrowing much more expensive (especially for the Federal government).

So there will be no reconciliation that makes all (or even most) parties happy. The inflation genie is indeed out of the bottle, and I'd sure hate to be Ben Bernanke, trying in vain to stuff the cantankerous bastard back in.