Monday, March 07, 2005

Inflation Shall Rise Again

Rather than the deflation, the real risk to the US economy is inflation. Slowly, more and more people are starting to believe it. Today, I found that Nouriel Roubini's web site has an entire section devoted to the topic. People are starting to catch on to the theme that will dominate over the coming decade.

It seems clear that the US is in a position of excessive indebtedness, with its net foreign liabilities at over 30% of GDP. It is also clear that the US has a fantastic advantage over other countries that have found themselves in a similar position, such as Argentina. That advantage, of course, is that most of the assets that foreigners own in the US are denominated in dollars. Moreover, a large proportion of the assets that US residents own abroad are denominated in foreign currency.

If the US is in over its head, then the easy way out is clearly to let the dollar weaken. My guess, and that of many observers I trust, is that the dollar will have to weaken considerably, as the US needs to not just water down its existing liabilities, but there actually needs to be a correction in the trade balance. Worse yet, if the world catches on to the fact that the dollar is a one-way bet, and central banks in Japan and the developing world stop supporting the dollar, US interest rates will probably jump, and the current account will get bigger because interest payments on existing liabilities will go up.

All this spells lots of dollar weakness for a very long time, which is exactly what we’ve been seeing for the last three years.

Dollar weakness, in turn, is inflationary no matter how you look at it. If the rest of the world tries the China/mercantilist way out and buys dollars to keep its currency weak, they will be printing currency to buy those dollars (how else do you do it?) and therefore stimulating their economies, ultimately causing prices of things to go up. This is clear from the experience of China, and the prices they’re driving up happen to be commodities, and in this way the inflation is bouncing around the world like a hot potato.

The dollar wants to weaken, but the Chinese don’t want it to weaken so they buy reserves, but this causes their money supply to expand (sterlization doesn’t work) and therefore economic activity to speed up, thus driving up the demand for commodities, and thus the 24 cents extra that you’ll have to pay at the pump next month is ultimately the work of the Fed, either directly or indirectly.

Play this movie for a while and you see inflationary pressure only building up. As firms discover that the prices of inputs (metals, lumber, paper, energy, coffee, orange juice, you name it) are permanently rising, they will be much less reluctant to pass on these costs to their customers. Consumers also catch on to the fact that prices are rising, and inflation expectations rise. We know from economics that inflation expectations easily turn into actual inflation.

I see no way around this. Creeping inflation will be with us for years to come.
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