Here Comes Inflation

Judging from yields on long-dated corporate and government bonds, it seems implausible that inflation will rear its head anytime soon. Indeed, the most recent annualized increase in consumer prices (the CPI) was reported to be just 1.7% in the three months ended February 2004.

Despite this, I believe the evidence is heavily skewed toward a scenario in which inflation would come roaring back. The culprits: increases in commodity prices, rising capital spending, falling unemployment, and a sinking dollar.

Commodity Prices
Although the media has focused on that 1.7% annualized increase, that figure excludes volatile food and energy prices. If you include those, the CPI actually rose at an annualized rate of 3.7% over the same period. And things could get worse.

Commodity prices are at multiyear highs and still rising. These commodities include steel, rubber, timber, natural gas, lead, zinc, aluminum, platinum, and oil. Soybean prices on the Chicago Board of Trade are up 40% from year-ago levels. Corn rose almost 25% in the same period. Silver prices are at a six-year high, and gold prices have risen dramatically.

Key factors in all this are the prices of oil and, to a lesser extent, natural gas. Abrupt changes in oil prices have implications for a variety of industries. Although U.S. consumers don't spend a large percentage of their paychecks directly on oil (or gas), they do indirectly. Oil and gas prices have implications for the airline, trucking, shipping, and manufacturing industries because they are heavy users of oil and natural gas as energy sources. With oil at a 13-year high and natural gas prices soaring, producers will be forced to raise prices or lose money. Thus, it should come as little surprise that prices for airline tickets, groceries, gasoline, automobiles, industrial equipment, and capital goods must rise.

Even industries that use coal instead of oil or gas will see an increase in input costs, because coal is considered a substitute for oil and gas. When the prices of oil and gas rise, producers use more coal because it's cheaper. This increased demand quickly results in higher coal prices, as well. And indeed, coal prices are now at multiyear highs.

For these reasons, the notion that we should "exclude" energy prices when thinking about inflation is hard for me to take seriously. Energy prices just have too much impact on the economy to be ignored.

Dollar Down
The U.S. economy relies heavily on imported goods. When the dollar falls, as it has recently, imports are more expensive to U.S. consumers. When imports are more expensive, it means that domestic companies can raise prices without losing customers to foreign competition.

So, when the dollar falls, it often brings a nasty round of price increases. We've seen this in the steel and rubber industries lately, among others, and when steel and rubber prices rise dramatically, guess what happens to the cost of producing an automobile. Not only will gas be more expensive, the cost of buying an auto in the first place will rise.

In short, owning a car will be a lot more expensive. Oh, did I mention that auto insurance rates are also surging due to higher medical and repair costs?

Demand for Corporate Loans
Economy.com reports that corporate lending is perking up. This comes after four years of low demand for corporate loans as companies dug in, downsized, repaired their balance sheets, and cut capital spending. Last year, hundreds of public companies took out debt at low rates, but most of this was refinancing activity and did not contribute positively to the net amount of debt outstanding. In recent months, however, this situation has begun to change.

Corporate balance sheets are as healthy as they have been since 1997. The ratio of corporate cash flow to debt interest payments is now the lowest it has been in decades. Companies can easily afford to take on more debt. Thus, there is going to be higher demand for money by U.S. corporations. Companies will use this money to increase capital spending and advertising, and soon thereafter, start hiring employees.

Looking at it from a different angle: If you expect inflation to rise above, say, 3%, the increase in corporate-loan demand is no surprise. At a 3% inflation rate, real aftertax interest rates on investment-grade corporate bonds are now less than zero. Thus, loans are essentially free money at today's rates (assuming inflation rises to 3% or more). Because of the Fed's easy money policy, lenders haven't raised rates yet, so smart companies should be leveraging up heavily now while they can lock in very low real rates.

If inflation really is on the horizon, why don't lenders demand higher interest rates? History shows that the capital markets have often misjudged inflation because of the psychological phenomenon known as recency bias. Lenders charge too much for money during times of very high inflation and too little for money during times of low inflation. In the latter case, lenders often end up getting a negative real return on their money in subsequent years. They suffer this fate because they expect the recent past to continue for many years into the future--they weight the recent past too heavily in their expectations.

As for the media reports of a continuing "jobless recovery," I say wait a couple of months. Pretty soon, I think we'll see a massive pickup in hiring, as always happens when capital spending and corporate loan demand are increasing.

If you still haven't refinanced your house, now might be a good time to do it.

The Stock Market
How will a pickup in inflation affect the stock market?

I believe, initially, it will have a negative impact because of what it means for the Fed's monetary policy. If and when inflation picks up, the Fed will be forced to raise interest rates. This will lower the money supply, and investors will no longer be awash in extra cash looking for a home. People will take money out of stocks, and speculative stocks will be most affected because they are more sensitive to short-term swings in market psychology and money flows. The Nasdaq will fall. So will the NYSE, but less because the average NYSE stock isn't as speculative.

This is not an exciting outlook, but one that I feel is likely if inflation comes about suddenly. For some reason, few people seem to be expecting inflation. I hope the majority is right, but I wouldn't put my money on it.