While prices of commodities from corn to copper are rallying, don’t assume that inflation is staging a comeback.
According to some of the most telling tea leaves in financial markets, concerns about a return of inflation, at least in North America, are misplaced.
Consider the price of gold, the hard asset seen as the ultimate hedge against rising prices. To the dismay of gold bugs, the precious metal’s price has been mired for most of the past month in one of its most brutal selloffs in years, hardly a harbinger of inflation.
Or look at another critical, inflation-sensitive market, perhaps the most sophisticated and forward-looking of them all: the credit market, where institutional investors trade billions of dollars of bonds, determining the level of long-term interest rates.
Traders here haven’t hit the panic button over inflation either. For countries not caught up in the sovereign debt crisis, interest rates on government debts remain near some of the lowest levels ever. If inflation were a credible threat to the future value of money, bond prices would be cratering, and interest rates rising sharply.
That’s why many market watchers believe the current jitters over inflation may be a giant, economic version of a head fake. These pundits believe the chances of anything resembling the last inflationary blowout in the 1970s – when years of double-digit hikes in consumer prices created a worldwide wage-price spiral – are remote.
Some analysts are even warning that inflation should be the least of our worries. They believe the most dangerous long-term problem is the high risk of inflation’s more scary opposite number – deflation.
Governments responded to the 2008 financial crisis by running huge deficits and printing money. According to the deflationists, once governments stop, the economy will weaken because of high debt levels, and the pressure on prices will wilt.
“When you proceed along this path of rising aggregate indebtedness that ultimately leads to contractions and … when you have extreme over-indebtedness and serious contractions, you get deflation,” contends Lacy Hunt, economist at Hoisington Investment Management Co. in Austin, Tex.
If inflation isn’t coming back, what then is happening?
Mr. Hunt, whose firm has one of the most successful track records in the bond market, believes the U.S. Federal Reserve, through its program of printing money known as quantitative easing, has caused massive flows of funds into commodities, emerging markets and other speculative investments. The quantitative easing program is set to expire in June, and Mr. Hunt doesn’t think it will be renewed, suggesting the price distortions it caused will be reversed.
Another big driver behind rising commodity prices is China, where torrid growth has led to galloping increases in demand. However, Mr. Hunt says pressure is building on the government there to cool things off, in case rising food prices lead to social unrest.
“I think you’ve got a Chinese economy that is careening out of control,” he says. One warning sign: Chinese money supply is rising at 20 per cent a year, a rate that isn’t sustainable and will require economic pain to bring down. Mr. Hunt doesn’t think China’s monetary authorities, facing a need to curb this type of money growth, will be able to engineer a soft landing for their economy.
Mr. Hunt thinks the likely outlook is for a mild, Japanese-style deflation to take hold in the U.S. over the next few years, with consumer prices falling a percentage point or two a year. In his view, any rise in long-term interest rates resulting from misplaced fears of inflation would be a good time to buy U.S. Treasury bonds, which would benefit if his deflationary scenario comes to pass.
Even some commodity bulls, who have been coining money from their big investments in corn, wheat, and other hard assets, shrug off the threat of imminent inflation.
“If you have to say what is it that keeps you awake at night, it’s not inflation,” says Don Coxe, the head of Coxe Advisors LLC, a Chicago-based money management firm.
