The Worst of All Outcomes: Inflation Plus Deflation
OPEC has just concluded its latest ministerial meeting, having decided to keep production quotas as they are.
The oil cartel must be commended for their able management of the market. 2008 saw an extraordinary price spike which contributed significantly to the global recession. It was followed in short order by a price collapse threatening to bankrupt some of the oil producers. OPEC successfully weathered both, bringing oil prices back within a range tolerable for both oil sellers and users.
But the road ahead remains tricky. The global recovery is so tentative that even a small drop in supply could strangle it, while an increase could result in a new price collapse. OPEC members are fully aware of the immense liquidity pool created by central banks, with mountains of cash ready to flow into speculation on oil futures.
With such potential even a small tightening of supply can cause another massive spike, possibly higher than last year.
And this brings us back to inflation.
According to the U.S. Federal Reserve, inflation will not be an issue for a year or two, despite the huge recent increase in money supply. The recession has created so much spare manufacturing capacity that the price of goods cannot rise. In parallel, high unemployment will prevent labor costs from increasing.
There are, however, two ways to look at inflation.
One is to see it as a rise in the cost of goods and services. The gage preferred by central bankers to measure it is the so-called core inflation, which measures the price of a basket of such items, but excludes food and energy, considered too volatile.
The low expectation for future inflation is based on this definition.
The other way to understand inflation, however, is as a reduction in the value of money and, consequently, of purchasing power. This is the definition the average consumer lives by. This person is not particularly interested in core inflation, which deals with price changes in the longer term. But he or she is highly sensitive to the cost of food and energy.
In a nutshell, the prices which really impact the consumer, and particularly the U.S. consumer, are those of gasoline, beef, milk and eggs. They do so all the more if they become volatile. Prices of other items are less important because their purchase can always be delayed.
The volatility of food and fuel prices will not go away, because the gap between global supply and demand of both oil and foodstuffs has been steadily narrowing, and will close even faster if a true economic recovery occurs.
At that point the global liquidity so freely pumped up by governments will flow into commodities and almost instantly amplify any price increases caused by demand. We will then have 2008 all over again: the cost of essential items rises disproportionately, the consumer takes a major hit and retrenches, and the economic recovery goes into reverse.
After a few such episodes, the consumer will hunker down for good and deflation will set in.
In other words, there is a strong likelihood that the current policies will cause a series of narrowly focused inflationary spikes leading in the end to a deflationary situation. Because of the cognitive disconnect between the monetary authorities and the average citizen, the measures designed to fight deflation will instead result in entrenching it.
The problem lies with the almost exclusive focus of the central bankers on the financial system. In theory, the purpose of this system is to steer available funds towards productive investment opportunities. But the system has become so large and convoluted that its internal activities now trump investment in the real economy.
Speculation in oil futures is much more profitable than investment in a new oil field or refinery. The fewer refineries are built, and the fewer oil fields are developed, the more profitable speculation becomes, as it thrives on demand-supply imbalances.
If central bankers want to avoid a long and painful deflationary period, they need to understand that shoveling money into the financial system is only an initial step. What is critical is to push the money through the financial system and into productive uses.
Printing money is easy. Investing it well is the difficult part, but also the one that powers the economy.
About the author
Jacek Popiel's career spanned military service and international business development. His new book outlines how energy, economics and politics converge on the current world scene. For more articles and information: http//www.viableenergynow.comTags: commodities speculation, consumer behavior, monetary expansion, quantitative easing