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fixed income

Something does not make sense. In February, the year-over-year inflation rate in the U.S. was 2.1 per cent and in Canada 2.2 per cent.

But inflation today doesn't seem to be just about 2 per cent. It feels much higher.

We all experience higher inflation when we go shopping. Although food, fuel, consumer goods and so on have gone up by more than 30 per cent in the past two years, the CPI has barely moved. But the markets for real assets - gold, food, energy and commodities - continue to rise, which suggests inflation.

What is going on?

Even the Bureau of Labor Statistics (BLS) in the U.S., which is responsible for canvassing consumers on how they spend their money and recording the prices of items consumed, has recently admitted, according to a report by Business Week, that its methods are "increasingly out of touch" in the age of cellphones and computers. And inflation numbers calculated by an economist at MIT, who has developed software that scours the Web and records the prices of close to five million items, are running much higher than official inflation estimates. And this economist is only tracking items sold over the Internet, which are bound to be more competitively priced.

But it is governments in the U.S. and Canada that define CPI and inflation. And so there are two key factors that restrain reported inflation, making it feel unrealistic to most consumers.

First, quality adjustments mask inflationary influences on prices of goods and services. In other words, even if you pay a higher price for an item, when government agencies make an adjustment for the fact that consumers are getting a better-quality item, the price does not seem to have increased much. But this is more illusory than real as consumers still have to pay a higher price for what they consume.

Second, the CPI no longer measures the prices of a fixed basket of goods, but it rather assumes that people substitute cheaper items for those whose prices rise. This may not be the case for most people. It is always easier to go from the lower quality to the better quality, but it is not so easy to go the other way around - such is life.

Even if inflation is really in the reported 2-per-cent range, it's not going to be that low for much longer. Buying a basket of goods will cost much more in the future. This is because the money multiplier, which determines the expansion of a country's money supply, has collapsed as money injected into the system by central banks is not being lent. This prevents the central banks' money creation stoking inflation. But this will not continue to be the case in the future. As soon as confidence is established, beware.

Already, at the producer level prices have been rising at a much faster pace - for example, producer prices in the U.S. rose much faster than expected in February on a monthly basis and increased 5.6 per cent on a year-over-year basis.

There are other reasons for future price pressures. Chinese spend about 39 per cent of their disposal income in food; in Indonesia it is 45 per cent. Food prices have been a major contributor to China's and Indonesia's soaring inflation. It is in emerging countries where most of world production takes place, and with such price increases, wages are bound to rise to prevent uprisings such as the ones we see in North African countries of late. As a result, the cost of making many of the goods imported by Western countries will rise.

Moreover, China is rapidly moving from mainly a producer country to mainly a consuming country as more Chinese citizens enter the middle class. They will be spending more on food, entertainment and travel. For example, recent reports show that the number of Chinese taking vacations is soaring and, according to other reports, China is expected to be the primary driver of air travel worldwide.

Instead of its dampening effect on global inflation over the past decade, in the future China will be contributing to global inflation. One only has to look at what has been happening to Australia. The TD Securities-Melbourne Institute measure of consumer prices rose 3.6 per cent in February on a year-to-year basis - and has been above 3 per cent since September, 2010, which is higher than the 2- to 3-per-cent target rate of the central bank. The rise is partly due to Australia's proximity to the booming Asian markets and spending sprees by Chinese and other Asian tourists.

I expect bond investors to wake up eventually, lick their wounds and then kick themselves for being so gullible as to believe the reported inflation statistics.