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Bernanke’s view on inflation, I think

Fed Chief Ben Bernanke did his first post-FOMC press conference yesterday. Predictably, he got a question about the impact of energy and food prices on the public and the whole issue of the impact of QE on inflation and the value of the dollar. There’s a lot of screaming and yelling about this subject in the press and among market participants. Bernanke held to his line, though, about inflation being low and these food and energy things being transitory, which annoyed a bunch of folks.

Here’s what I think Big Ben is reading the inflation situation. I’ll try to explain by way of example.

Imagine that you have $100 in your budget. Your housing (rent or mortgage) is $35. Food runs $25. Utilities and other expenses are another $25. Gasoline costs $15. Now let’s say gasoline prices double, so your cost goes to $30. What happens? If you cannot increase your income or borrow money you’ll have to cut $15 from among the other categories. That means your demand for other goods and services will go down.

Extend this example to the whole US economy. If income isn’t rising, then rising food and energy prices means money not available to spend on other things. That means less demand, and by extension lower prices in those sectors. What that tallies up to is no net change in overall prices. Even if income is rising, as long as it’s rising less rapidly than the increase in food and energy prices there will still be the dampening impact on prices elsewhere in the economy.

Below is a chart from the St. Louis Fed showing disposable income over the last 10 years. It show’s a year-over-year growth rate between 3% and 4% in the most recent figures. How does that compare to the change in food and energy prices? Just a fraction, right?

Of course, folks can borrow to make up the shortfall. Are they? To find out we need to look to the money supply figures.

Here’s the chart for the Monetary Base, which is the lowest level of money supply that is directly influenced by what the Fed does.

Again, we’re looking at year-over-year changes here. Notice the big spike up in 2008 when the Fed got aggressive about dealing with the financial crisis. In late 2009 and early 2010 we can see a spike up in the growth rate from QE1. The growth rate actually went negative in the latter part of 2010, though, before QE2, after which it has bounced back again.

The monetary base, however, does not reflect borrowed money. That’s in the bigger aggregates, especially M3. The Fed stopped publishing M3 a few years back, but we can see a continuation version created by the folks at ShadowStats.

Notice in the chart how the y/y change in M3 has been negative since late 2009 or early 2010. That basically means the amount of debt outstanding has been falling. In other words, folks in the US have not been borrowing to finance purchases beyond their income. Quite the opposite. They’ve been reducing debt (though write-offs are a factor here).

So what we have is income not rising at the same pace as increases in food and energy prices and debt shrinking, not expanding. That means there’s less money available to be spent on other goods and services. That is helping to depress prices in those sectors, which is why Bernanke is not worried about general inflation yet, but does have concerns about economic growth. At least that’s how I think he’s viewing things.

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Taxes, Budget Deficits and Inflation

A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.