Thoughts on inflation

"Inflation is always and everywhere a monetary phenomenon." - tons of Economists

With equity markets dropping today and a record increase in Non-Farm Payrolls, I thought I would begin a discussion on the determinants of inflation and what it means when there is a recession and what it means for asset allocation.

Inflation really only makes sense when you refer to it as the debasement of a currency. Simply put, governments and central banks print too much money in order to reduce interest rates. Consumers borrow more and drive up the prices of existing goods. The market process contribution to this reasoning is that the changes do not happen instantaneously, but happen over time. This causes real dislocations in the economy which helps bring about the business cycle.

Market process theorists, monetarists, and others have used money supply data to guide them to central banking policies towards the creation of money. I really don't have the answers as to which one to use or not not use. For example, I don't know whether Travelers Checks or TAF should be included. I prefer to stick with monetary base adjusted for inflation (so that I can compare it between periods). Monetary base is cash plus reserves, it's simple and easy to use. The long-term change in this statistic is a good indicator to reflect monetary policy. When it is increasing, it means the Fed is creating money faster than the money is being debased.

This graph is courtesy of Paul Kasriel. Periods of increasing real monetary base are associated with boom times and periods of decreasing RMB typically coincide with recessions or other economic crises (not necessarily a recession defined by NBER). Currently facing a period of declining RMB, we could have expected one or the other. The question to ask is, what now?

To understand the current inflation, it should be clear that agriculture and energy prices are a large component in headline CPI. For example, the energy CPI index was .7% in January compared to .3% for the core number. Looking at the CPI chart below, core commodities, however, are actually relatively flat compared to the last boom. Core commodities (excludes food and energy commodities) also dropped significantly during the last recession as core commodities do. The reason is that as economic and industrial activity slows, metals such as zinc, copper, and aluminum are in less demand. If there is to be a recession, or any further slowing of economic activity, these core commodities will likely enter a bear market over the course of the slowdown.

Several market commentators are still worried about the possibility of inflation despite the fact that RMB is most decreasing. This is mostly due to a long-run bull run in commodities driven by agriculture and energy prices and a weaker dollar. Indeed, if we are entering a recession, industrial minerals should be beat down further than they are.

Above are the graphs for the past two years worth of DBA and DBB (the agricultural and base minerals etfs, respectively). DBA (and GLD and USO) have all been on a run lately. Some of this run is certainly based on fundamental factors (ethanol, the collapse of the financial markets, and market's determined belief in peak oil). However, I would caution anyone looking to put on new positions in these commodity classes to hedge your risk by shorting a value of DBB equal to the whole value of those positions. If the market thinks inflation will be coming down, industrial minerals will decline faster than the others since it fundamentally should do that. The spread will certainly widen though it might make sense to wait to put on the long side of the spread until there is a pullback or a naked position on the short side until the recent trend shows signs of ending. You don't have to think that inflation is going to decrease (which it usually does in recessions, but not always), but just that industrial minerals will decrease more than the rest of commodities.