April 12, 2016 Leave a comment
The common thinking of the day suggests that the world is in a state of deflation. This is when prices for goods are going down in price. Inflation is when the prices for goods are increasing in price. The published numbers for the CPI in the developed world has been showing low numbers of inflation and occasionally deflation. There is disagreement on what the numbers mean and whether they are indicative of the state of the economy. Ignoring this possibility, is inflation set to return to the market as indicated by the CPI?
Where does inflation come from? There are two main theories. The first one comes from producing goods and the associated costs. The production of anything requires 3 main costs – labour, materials and overhead. There are some hidden costs like taxation and debt as well which are embedded in the cost of production. Looking at the trends, the cost of labour has been declining as well as the price of materials. The stagnation of wages and benefits as well as lower commodity prices are proof of these trends. The increase in automation is also adding to reduced costs for all of the inputs. The second theory involves the production of the measuring unit – money. This is what is called monetary policy, and the basis of this thinking is that if you add more currency units to an economy, the prices of goods will go up even though the actual labour, material and overhead costs have not changed. This is like issuing more shares in a corporation and diluting the value per share, even though the value of the company remains the same.
Using both of these theories, labour, commodity prices and debt servicing costs are at multi-year lows. Automation may continue to reduce the need for both of these things but there may be social consequences. Overhead costs are rising slowly – utilities, rent and taxation. On the monetary side, zero interest rates and large injections of currency units suggest that inflation will surface sooner or later. The central banks also want to have some degree of inflation because they believe it will create more consumption.
What is the future of these trends? The labour costs are not rising significantly. Commodity prices have risen in 2016, but they are down from their highs and are still relatively cheap. Overhead costs are rising somewhat due to higher real estate prices and utilities costs – but the underlying reason for this is the increased usage of debt. The debt costs are rising and may rise significantly along with the cost of taxation if interest rates rise. This is not evident in the trends but is a “black swan” event that may produce a significant increase in inflation. There doesn’t seem to be a predictable indicator of inflation returning to the market. Inflation is there within the numbers and can be unleashed unexpectedly however.