Sunday, May 25, 2008

Understanding inflation concerns

Last year, when oil was close to US$90 per barrel, I indicated that it would go to US$100. In an article I wrote in March, when oil was US$105 per barrel, I indicated that by April/May 2008 oil would hit between US$110 to US$120 per barrel. There were persons who publicly, and privately, said that I did not know what I was saying and that oil would soon go back down to US$85 per barrel. I even remember someone saying to me that I was talking up the price of oil, even though I am a mere accountant in a country that is responsible for a very insignificant amount of global consumption. But such is the emotion called illogic that so many of us seem to possess.

When one looks at the daily oil chart it still shows a very bullish trend, and on that basis some had said that they expect oil to still continue rising unabated. At the same time we are facing rapid increases in global food prices, as evidenced by a very basic staple, rice, which already this year has increased by 117 per cent. There are reports also that Costco and SAM's club, in the US, have been restricting the sale of rice. There are reports that in over 33 countries across the globe there have been food riots this year already.

Again, I believe that emotion is taking over, and people are not correctly analysing the situation and now the talk is that this trend will continue indefinitely. So people have transformed from telling me that I don't know what I am saying about oil prices going to US$120 per barrel, to the point now where they are saying that these rises are going to continue indefinitely and predicting indefinite doom and gloom. Now anyone who understands how markets work will realise how irrational these arguments are, and will also appreciate that what is driving these comments is nothing more than emotions.

Food inflation
I do admit that food inflation will be the greatest concern for Jamaica, and the world, in 2008. As a matter of fact it is a greater crisis today than the price of oil, which was a greater crisis last year. So today it is more important to deal with the threat of food inflation than the price of oil, whereas last year oil prices were more of a threat to the economy. This is the dynamic nature of the markets, and even more so in this electronic age, where policies must be nimble enough to deal with the crisis of the day as they will continue to keep changing, especially in times of great uncertainty and market instability.

Both food and oil will on average be higher than last year, but the fact is that the rate of inflation will slow down. So when the critics say that inflation will continue to be high, at around the same rates as last fiscal year (20%) then it really speaks to a lack of understanding of the concept of inflation. Let us take an example; oil rose from US$70 per barrel last year to US$120 per barrel this week, which is a US$50 absolute increase or 71.4% over last year. The same US$50 increase over US$120, however, is only a 41.7% increase, which is 30% less than the prior percentage.

This is the concept of inflation. It is not that prices may not increase but that the rate (% change) of increase is going to slow down. The slow down will result because of two reasons. The first is that the base on which the inflation rate is computed will be larger, thus the rate of increase will be lower, and the second, in my view, is that towards the third to fourth quarter of this year, oil and commodity prices will start to back off.

The greatest threat to higher local inflation is in fact something that no one has been speaking of, that is the threat to our local food supply from a natural disaster such as a hurricane.

US dollar recovery
The slow down in prices will result also from a stronger US dollar as well as equilibrium being achieved between demand and supply for food. The fact is that there is a speculative relationship between US dollar weakness and the higher prices in oil and other commodities, which accounts for approximately US$20 to US$30 on current oil prices. This results because traders, and investors, seek to protect the real value of their holdings by bidding up the price of commodities to compensate for the weakness in the US dollar. The US dollar, however, will strengthen in the third and fourth quarter for the following reasons:

. The economic data out of the US is showing signs of stability. While there are still some negative signs in the housing market, there are signs of a slight recovery in jobs and company profits over the expectation of economists.

In fact, even though the most recent jobs data shows a slight decline, the sector of small businesses showed a strong 55,000 addition. This is a sign that the economy has started to reach a bottom and could start to recover soon;

. The Fed is expected to cut rates by just 25 basis points at its next meeting and then be finished with rate cuts. The present threat of inflation means also that as the economy shows signs of stability the pressure to decrease interest rates will subside and in fact if prices continue to rise then rates may even go back up slightly;

. Other economies have already started to show signs of weakness, and in fact countries like the UK have already started to reduce interest rates. As the expectation of rate decreases falls in the US and increases in other countries then the interest differential between the US dollar and other currencies will decrease thus causing strength in the US dollar; and

. As the US shows signs of recovery then the equity market will start to recover. This will lead to investors putting risk on the table again and selling the Japanese yen against the US dollar thus causing strength in the dollar.

As food prices increase you will find more food planted globally. This will in turn increase supply and as countries, such as Jamaica, seek to increase local food production and also move to greater self- sufficiency, then demand will also be tempered.

These two factors will combine to reduce food prices towards the end of the year. This will result in a lower rate of inflation over last year, as when you are close to the plateau of prices it is difficult to have the same rates of increase. This is logical.As I have always said though, I think ethanol is over-rated as a fuel source, and in fact it has been one of the reasons for the higher food prices. The US, through Congress, has mandated that 25 per cent of corn production should go to biofuel production. What this has done is reduced the supply of corn for food consumption, placing pressure on the price. Now all my logical senses tell me that faced with food shortages or higher energy prices this mandate will be lifted, as eating is always going to be more important than driving. With the expected fall in oil prices also we will see less emphasis on using our food sources for energy. In any event I have always believed that coal is a better option.

Although we have seen that the prices of rice and corn commodities have increased, we have also seen that the prices of live cattle and milk, for example, have decreased this year. So the picture is in fact mixed.

The fact though is that markets always behave in this manner when trying to find equilibrium. So it will spike up and go down until it finds the equilibrium price, and this is influenced by market forces such as changes in supply and demand. So will prices be higher than last year on average? Certainly. But the rate of increase will be lower than last year, which is what inflation is.

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