James Hamilton of UCSD has unveiled the “mission accomplished” banner after QE2 caused a speculative ramp in commodity prices in recent months. He writes:
“I guess now we know that the Fed has the tools to prevent deflation.”
This is an interesting comment considering that the Fed is still worried about deflation even after unleashing these same “tools” in 2009 and early 2010. I think Professor Krugman has already accurately tackled the inflation/commodity problem, however, it’s worth repeating:
“Right now everyone seems to believe that rising commodity prices are telling us to beware of inflation. I think that’s dead wrong. Partly that’s because the sticky prices are the ones to worry about.
Professor Krugman also points to an interesting factoid regarding the current debt deleveraging:
“It’s also worth pointing out that the commodities price spike of 2007-2008 was seen by some as a harbinger of major inflation; they were wrong.
There’s really nothing here to shake my view that deflation, not inflation, is the threat.”
Why was $150 oil followed by one of the greatest deflationary busts in the last 100 years? Because the price increases were not supported by the underlying fundamentals. As wages compressed and the debt bubble was pricked the consumer was exposed for being the weakling that it is. We are seeing a similar occurrence now in several markets.
Gaius who writes the very excellent Decline and Fall of Western Civilization chimed in on Professor Hamilton’s comments with an accurate portrayal of what QE is doing to prices:
“I have to say, in spite of my respect for your erudition, Prof. Hamilton, I disagree entirely with your conclusion.
That anticipation of QE might have fueled a speculative rally which predominantly flows into commodities thanks to reflexivity — that i think we can agree on.
That QE itself is an inflationary phenomena remains totally unevidenced — to the contrary, observe core inflation readings in the context of QE1 and QE lite, please!
You’re taking a speculative leveraged flows into notoriously volatile raw inputs and end-of-the-capital-structure financial instruments and from that construing that a fed measure that hasn’t begun yet causes inflation? Color me bemused.
I think it far closer to the truth to say that the fed plans to exchange some very-cash-like assets out of the private sector and replace them with cash itself. That very minimally alters the character of net private sector financial assets, and should not be expected to do much of anything — as indeed QE has in the past rarely if ever accomplished much of note outside of a liquidity crisis. If wall street wants to take the anticipation of QE as an excuse to flood speculators with call money, taking advantage of popular misconceptions of what QE is and what it can do to create standard-issue speculative demand for assets, that’s another thing entirely.”
And this is really the key here. QE does not add new money to the system. Therefore, it is not inherently inflationary. There are not more dollars chasing the same number of goods. There has certainly been the perception of this (due to misconception) and even some borrowing to buy risk assets, but ultimately, without an increase in the amount of currency in circulation the only thing that will justify these higher prices is higher wages or a surge in borrowing. Unfortunately for working class America wages and lending are dead in the water.
It’s more likely that these commodity price increases are causing more harm than good and corporations will have a very difficult time passing any costs along. This will result in compressed margins and more hesitancy in hiring.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.