John Taylor's Controversial Outlook On Inflation: "Not Here, Not Now"
John Taylor, traditionally one of the most insightful strategists, has released a controversial note looking at the prospect of surging inflation, which he says is not much of an issue, "because the global economy is suffering from excess manufacturing
capacity and a deficit of consumption, history tells us there is little
chance that inflation will be a problem." We wholeheartedly agree with him on this point... to an extent. All the African countries experiencing food riots also have record high unemployment: read massive excess capacity, manufaturing and otherwise. Thus, at least in the developing world, the two are no longer related. Is that the case in the developed world? With enough money thrown at it, the answer is a resounding yes. Should the Chairvillain continue his money printing "third mandate" duty, we are confident we will be proven correct soon. And after all, as many have speculated, the Fed has no other choice to deal with the massive debt load. Additionally, if as the WEF is correct, and world debt stock has to double to over $200 trillion in a decade, the bulk of that debt will have to be acquired by assorted central banks: read - monetization...whose one certain side effect is a surge in excess reserves, and thus, inflationary expectations. Should the ill-defined concept of velocity pick up even a smidge, it is game over for the monetary system, and not just regionally, but globally. Which is why we are in full agreement with Taylor on phase 1 of the reflationary experiment, he is short on the second phase, namely the one in which Bernanke continues to print, print, print, drowning out all incremental deflationary threats from "excess capacity" which always has just one monetary outcome...
Inflation, Not Here, Not Now
January 20, 2011
By John Taylor
Chief Investment Officer, FX Concepts
Commodity prices are flying higher, interest rates are near zero, base money growth is staggeringly high and inflation expectations are going to the moon. It looks like inflation is back, but it isn't the kind of inflation the Germans worry about or the kind that leads to high interest rates followed by a deep recession. If this is not the inflation of post-WWI or the 1970's, then what is it? Although the current bout of food shortages and price increases have helped topple the government in Tunisia and led to food riots in Algeria, these commodity price increases and the excess money being spread around should not have any impact in the G-10 countries, unless some central bank makes a big mistake and hikes interest rates. Why is it so different this time around?
Because the global economy is suffering from excess manufacturing capacity and a deficit of consumption, history tells us there is little chance that inflation will be a problem. If we just look at the second half of the 1930's, the prime example of a consumption shortfall, when interest rates were exceedingly low and base money was growing sharply (because Roosevelt had changed the price of gold), many were worried about inflation but it never arrived. Fed Chairman Bernanke's QE efforts are only a pale shadow of Roosevelt's powerful inflationary stroke, but prices stayed subdued back then and they will now. With still climbing excess manufacturing capacity, and so much of it located in low- wage China, there is little or no wage pressure in the developed world. The situation was exactly the opposite in the 1970's when there was not only a shortage of skilled workers but many contracts were inflation adjusted as well. Now these inflationary adjustments are history except in some public pension plans (which are on their way to insolvency). Labor's pricing power has been declining since the 1970's. In the US the number of hours necessary to buy a car bottomed in 1972 and it now takes about twice as long for the average worker to buy the average car. Although monetary growth is a necessary condition for inflation, without tight labor markets it just cannot find the traction necessary. When the price of oil or food goes up, the weakened worker will drive less or eat less, he/she cannot drive wages up. Final demand stays the same but it is just spread around differently.
If commodity prices climb higher and higher, the American and European worker will tend to spend more for food and fuel, cutting down his purchases of manufactured items and locally produced services. Units of food and fuel purchased will drop as well, as each one is more expensive, cutting final demand and lessening the upward pressure on commodity prices. The raw material producers, generally the emerging markets, should prosper in relation to the manufacturing countries, shifting the balance of global power. This change in relative economic dominance matches the concept of the Kondratieff cycle and fits very well with MIT's capital investment cycle. The current period seems to fit nicely with 1937, and if we use that as a base date, the commodity producers will prosper for another 13 to 15 years as they did back then. Although the western countries will have a growth problem, not an inflation problem, the commodity producers will have plenty of growth and plenty of inflation. Although Australia, a perfect example in the early 1950's, with high growth and high inflation, controlled its overheating problems fairly well, this time around there will be many countries that have not tasted "capitalist" freedom before. As many of these newly wealthy countries have managed currencies with exploding reserves and money supplies, the next decade or so should see dramatic inflationary booms and busts, plus plenty of political turmoil. With the G-10 consumers facing a difficult 2011, global commodity prices should peak soon and inflation fears will melt away in the US and Europe.