Churchouse Letter
March 2011             by Peter Churchouse

Inflation: Cost-Push, Demand-Pull, Naivety or a Useful Construct?

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Central Bank Toolkits are Limited

In the wake of the Lehman collapse a panicked US Central Bank, Treasury and Political Machine rode to the world‘s rescue with a massive money printing pro-gram that was designed to prevent the imminent demise of the entire world‘s financial system. This first round of quantitative easing, an unheard of construct previously, and now something that peppers just about every corner of financial and economic discussion, was greeted with considerable relief around the world – from Wall Street to the City, Beijing to Brazil, Frankfurt to Mumbai. As the dust slowly started to settle, almost without exception, central banks and governments around the world started embarking on their own versions of QE, monetary and fiscal accommodation.

Early in the QE Cycle, Some Economists Sounded the Alarms: High Inflation Would be the Inevitable Outcome of Such Policies

Almost immediately economists attacked QE as being ultimately inflationary, and possibly hyper-inflationary, with visions of the Weimar Republic in the popular mind. Amongst economists in many fields, including those in the banks that had been bailed out (who said there is no independent thinking in our major banks?), rumblings of disquiet started to appear. The apparent solution to financial armageddon would likely transform into the next crisis, this time an inflationary one. Not to mention how governments were going to service all the debt that they created to absorb all that ailing paper that they were basically socializing.

This inflationary thinking is hardly surprising. Modern (and some not quite so modern) economic theory teaches that inflation is each and everywhere a monetary phenomenon – courtesy Milton Friedman. Ramping up money supply and dumping vast quantities of cash by 747 aircraft into the economy (Mr. Bernanke’s famous helicopters are just not up to the scale of this job!) will inevitably result in strong inflationary pressures according to the Friedman school of economic thinking.

However, this theory took something of a back seat in recent years while ultra-low interest rates dominated western markets. Lending blossomed, money supply was on the high side of average, but inflation, as measured by most governments around the world remained benign. How much we believe such measures is another question.

Thank You China for Apparently Demonstrating the Potential Flaws in Professor Friedman’s Inflation Economics.

China can be thanked for the world‘s apparent ability to have its cake and eat it. It has been a significant deflationary force in the global economy through its exports of low cost consumer goods which feature highly in most measures of CPI (consumer price inflation). This may now be unraveling as China is embarking on a policy of ramping up wages in its manufacturing industries and not by the odd couple of percentage points. Think more like 15% – 30%! In addition raw material input prices are rising sharply. From being a global deflationary force, China may now start to be a driver of inflation, or at the least, a much more neutral force in global the inflation stakes. China’s deflationary credentials may soon prove to be a thing of the past.

Rises in wages are China‘s way of responding to western government calls for a stronger Rmb. It is all inflationary to the west irrespective of which way they get there—currency or wages.

Average Annual % Change in Real Wages from 2006 - 2009. China Approximately 12.5%, India (based on 2006-2008) Approximately 2.5%, Thailand Approximately 1.5%, US Approximately 1%, Malaysia Approximately 0%, South Korea Approximately -1%, Philippines Approximately -1.2%, Indonesia Approximately -2.5%. Note: Chart shows % change in real wages for all employees, 2006-2009.

Is Growth a Good Thing or a Bad Thing?

Over the past 18 months or so, asset markets have vacillated in this concern over the inflation/deflation debate. Depending on prevailing market mood, growth is seen as a bad thing – it will produce inflationary pressures (bond markets hurt) – or a good thing – it will produce jobs and profit growth (equity markets rebound).

There is no doubt that inflationary pressures are emerging in the global economy. Asian economies have been probably the first major recipients of such pressures. First signs have not been seen so much in CPI pressures, but in asset prices, and most Asian governments and central banks have been quick to initiate polices to curb asset price inflation.

The Friedman school of cause and effect here is probably the correct one. Asset price inflation in the past 18 months (most visibly property prices) has been driven by extraordinarily easy monetary policies around the region. The printing presses have been set free in Asia, most particularly in China. Capital has also poured into the region courtesy of printing presses elsewhere. But in many markets supply of floor space is tight and genuine demand for space exists given relatively robust growth. It is not all about easy money.

Residential Property Price Indices in China, Hong Kong and Singapore from 2004 - 2010. Chart rebased to 100 in 2004.

The Next Dimension in Global Inflation

New dimensions to the inflation picture are now becoming very evident. Commodity prices, both agricultural and nonagricultural are making strong gains, putting rather more pressure on measures of CPI than the recent surges in asset prices. The World Bank‘s food price index increased by 15% between October last year and January this year. Over the past 6 months or so very substantial price increases have occurred in many of the most important foodstuffs – wheat, sugar, edible oils, maize, sorghum, and soya. World rice prices are up by about 17% in this period, but much less than many other major agricultural commodities.

World Bank Food Price Indices in US$ per Metric Ton (MT) for Food, Grains, Other from Jan 2007 - Jan 2001.Global Prices of Key Food Commodities in US$ per Metric Ton ($/MT) (Constituents: Thai rice (25%), Wheat, Sugar, Maize, Soybean Oil) from Jan 2010 - Jan 11.

World Rice Consumption By Country During 2010. China 31.6%, India 19%, Indonesia 8%, Bangladesh 7%, Vietnam 5%, Others 29.4%. The top 5 global consumers represent 70.6% of the world rice consumption. Note: 'Others' comprised of countries consuming less than 5% of total global consumption figures.

World Domestic Rice Consumption (Millions of Metric Tons) from 1988 - 2010.

World Corn Production and Consumption (Thousand Metric Tons) from 2006-2011. World Corn Production in Blue, and Word Corn Consumption in Red.World Sorghum Production and Consumption (Thousand Metric Tons) from 2006-2001. World Sorghum Production in Blue, World Sorghum Consumption in Red.
World Domestic Wheat Consumption (Millions of Metric Tons) with percentage increase Year-on-Year from 1988 to 2011. Consumption during 2009-2010 was well below the long term average. Compound rate of growth over the period 1988-2010 was 1.13% p.a.

World Wheat Production (Millions of Metric Tons) from 1988 to 2010 including percentage change Year-on-Year. Productivity has increased approximately 23% over the period 1988-2010.

Monthly Rice Prices (US$ per Metric Ton) from 1981 to 2010. Note: based on prices of 5% broken milled white rice. Thailand nominal price quote. US$ per metric ton. Source: IMF.


Nonfood agricultural commodities have also soared. For example the Dow Jones-UBS cotton price index is up close to 160% since the middle of 2010.

Dow Jones - UBS Cotton Subindex (DJUBSCT). 5YR Weekly, SMA (100) and SMA (200).


Price increases in these commodities is less easy to attribute to monetary phenomena a la Friedman than prices of assets and industrial goods. For example, recent growth of wheat consumption is well below the long term average, whereas corn and sorghum is flat.

Inflation as Cost-Push/Demand Pull – Is it an Outdated, Naïve Economic Construct?

Few academics talk of inflation in terms of cost-push or demand-pull these days. It is perhaps an unfashionable way of trying to understand the cause and effect of inflation, but was very much in vogue in the 1960‘s when I first studied economics.

Taking the cost-push/demand-pull concept as a basic construct, perhaps naively to the Friedman-ites in the economics profession, may help us simpler minds to formulate some understanding of the process and its causes.

The Friedman theory of inflation being everywhere and always a monetary phenomenon is easy enough to go along with under the demand-pull inflation construct. Demand for goods and services can only really manifest itself in the market if consumers and buyers actually have the cash to pay for the goods and services they want – either from earnings, savings or (as more recently) from successive rounds of borrowing.

If ability to produce goods is less than the ability to demand and pay, then price rises are the outcome. Ability to borrow for consumer goods has been supported by rising asset prices which in turn have been generated by easy access to borrowed money.

However, China‘s economic awakening as the low cost factory to the world over the past 20 years has helped keep traded goods prices low. There has been little inflation in most measures despite low interest rates and robust money supply growth.

Eurozone CPI vs Money and Credit Growth (M3). Left Hand Side: Total HICP as percent change over year-ago level from 2006-Feb 2011 (Change at 2.4 in Feb 2011). Right Hand Side: Money and Credit Growth as percent change over year-ago level from 2006-February 2011 (M3 in solid black line, at 1.4 in Jan 2011, Loans  in dotted line at 2.3 in Jan 2011). Note: Harmonized Index of Consumer Prices displaying percentage change over Year-Ago Level.

US CPI vs Money Supply Growth (M2). Left Hand Side: 'All Items' in blue dotted line, 'All items Methodologically Consistent' in solid black line (Note: CPI shows quarterly change, annualized). Right Hand Side: M2 Change from 3 months in solid black line, M2 change from 12 months in Solid Blue line (Note: M2 growth shows change from 3-months and 12-months earlier).


But of course the easy money has generated asset price inflation, mostly real estate. That does not feature much, or at all in the measures of CPI that our central bankers are tasked to monitor.

The cost push inflation construct can also be seen as a monetary phenomenon in certain circumstances. But in the current environment, many food experts and economists lay the blame for rising food costs for example, on weather changes, droughts, floods, natural disasters impacting on food supplies in varying ways.

Reduction of arable land in some countries, and diversion of agricultural commodities to other uses is sometimes cited as primary causes of food and agricultural goods inflation.

Everyone has to eat, but we don‘t have to buy a new car, TV or computer on a daily basis. Spending on higher cost food means less available for other goods and services.

It is less obvious that such inflationary pressures are indeed a “monetary phenomenon”.

The statistics do not show massive increases in annual consumption of most major agricultural commodities which might suggest cause for the very rapid rates of prices increases. Nor do we see, at a global level at least, huge mismatches in production and consumption where perhaps stock piles are being cut sharply in the face of rising demand, which could explain price increases through expectation of shortfalls.

The charts show global consumption of most food commodities as having risen along a steady path, increasing by less than 2% per annum.

Global Consumption of Key Food Commodities. Left Hand Side: Food Price Index for the years 2010, 2009, 2008 (where 2002-2004 has been rebased to 100). Right Hand Side: Food Commodity Price Indices: Sugar, Oils & Fats, Dairy, Meat, Cereals over 2010-2011 (where 2002-2004 has been rebased to 100).

The Blunt Stick of Interest Rates May Not be The Solution to Some Forms of Inflationary Pressure

Raising interest rates, the main response of central banks to inflationary pressures may be appropriate for taming asset price inflation (demand-pull inflation), but may be less effective in curbing much of the rising food price inflation that is starting to impact so many people around the world, particularly in emerging markets.

Careful What You Wish For

While inflation is now up-front and centre on many national agendas around the world, increasingly also in the developed world, where economic growth is at stall speed, there are a couple of observations we can make.

First, in a very unbalanced world, where developing nations are saving prodigiously and funding profligate consumption by the developed world, political rumblings over the last couple of years are suggesting that the solution to this imbalance is for developing nations to cut savings and investment and consume more. I think they mean go down the path that got the west into so much trouble!

But it is true that some countries in the developing world are in fact ramping up domestic consumption. India and China are good examples, most particularly China. Consumers in China have opened the wallets in a big way with domestic consumption typically running at 15% YoY or more these days. But to encourage growth of consumption (and achieve other objectives) the Chinese authorities are mandating very substantial increases in manufacturing wages, which, along with substantial increases in material costs, must ultimately reflect in higher prices at your local Walmart.

The west‘s calls for increasing consumption in the developing world in itself will likely end up adding to inflationary pressures in the west.

Inflation – Temporary Cyclical Phenomenon or a Longer Duration Secular Trend?

While the inflation camp seems to be holding the centre stage right at the moment, there are numerous reasons to think that the current surge in commodity prices of all kinds and the inflationary pressures that this is bringing is a temporary phenomenon, and will subside in the coming months. This is not the only big spike in commodity prices that the world has endured in recent years. The 2007/08 period saw similar spikes in most commodity prices, brought to a screaming halt by the onset of the global financial crisis. In many instances prices are still well below the levels achieved in that spike. So is the current spike just a head-fake to be followed by another decline in prices, or is this the beginning of a sustained period of inflationary pressures?

The case for each outcome seems finely balanced.

CPI for Selected Countries showing the 3 year average at the beginning and end of the period. Constituents: Japan, France, Germany, Canada, Italy, Great Britain, Eurozone (EU27), OECD, Korea, USA, Australia, Spain, China, Mexico, Ireland, Brazil, Chile, India, Turkey, Indonesia, Russia. Note: Consumer Price Indices comprised of price, labour costs and interest rates.

The Deflationary Oriented Case

Gary Shilling (1) makes a strong case for the more deflationary outlook. US consumers are saving again with the saving rate having surged from almost zero to 6%- 7% today. More savings means less consumption, less inflationary pressure.

Unemployment in the west is high – more deflationary pressures. Some western governments are tightening the fiscal reins – and even the US is starting to sound warnings bells in this regard.

Local government finances in the US are a mess, and fiscal restraint is almost guaranteed there. Deleveraging around the world is deflationary. Housing markets in the US and many western countries are weak and likely to remain so, with reduced ability to fund consumption through equity withdrawals and weaker prospects for construction sector.

And then there is the baby boomer western demographic. As baby boomers age, there is less need to spend on big ticket consumer items, and a need to save to fund retirement sets in with a vengeance.

(1, A. Gary Shilling’s Insight, December 2010)

The Sustained Recovery, Sustained Inflation Camp

The opposite camp cites recent improved data in a range of sources including modest pickup in consumer spending, auto sales coming off their low points, signs of improvement in the unemployment statistics, slight improvements in industrial production, bottoming of the decline in real personal incomes as reasons to think that the economy is back in recovery mode and that inflationary pressures are real and likely to be sustained.

Bear in mind that this camp WANTS to see inflation as it is seen as a sign of economic recovery. The stronger growth in emerging markets also provides support to this camp. An added support to this thinking is the recent exit of investment/portfolio flows from Asia and other emerging markets, assumedly for allocation to developed markets again. Developed world risk is back on the investment agenda.

Most of the major international agencies expect global growth to accelerate in 2011 – recovery is sustainable and real they think. The International Monetary Fund (an organization that pretty much missed the call on the global financial crisis), forecast global economic output recovering to 4.5% in 2011, a 25bp increase from their October 2010 forecast. The stronger developing world growth of around 7% is the leading component in this global forecast, but also includes a marginally improved growth outlook for the developed world (2).

The IMF does, however, caveat its rather rosy scenario.

“But downside risks to the recovery remain elevated. The most urgent require-ments for robust recovery are comprehensive and rapid actions to overcome sovereign and financial troubles in the Euro area and policies to redress fiscal imbalances and to repair and reform financial systems in advanced economies more generally. These need to be complemented with policies that keep over-heating pressures in check and facilitate external rebalancing in key emerging economies.”

That all seems pretty simple – a piece of cake really, no problems!

(2, International Monetary Fund, World Economic Update, January 25th 2011.)

Let’s be Honest ……

If we are at all honest with ourselves we have to admit that we don‘t really know with any great certainty which outcome will prove the more evident – sustained recovery with continued inflationary pressures, or a prolonged period of sub-par growth and low inflationary pressure, or a relapse of growth with inflation continuing – the stagflation scenario. As an optimist generally, I nevertheless find it rather difficult to think that the worst recession and financial crisis that the world has experienced in more than 70 years is all over and done within a two to three year “fix” period. I cannot determine whether the current spike in inflationary pressures is likely to be a short term problem or something that is more secular in nature. Parts of the inflation story seem secular, other parts probably more cyclical.

To the extent that food price spikes are a result of natural disasters, weather problems, the question remains as to whether these are one off events, or are a pattern of permanent change in climate, rainfall.

A period akin to stagflation in the developed world seems a fairly likely out-come, at least in the short term, and possibly longer. Developing nations are likely to witness a more typical period of high growth and inflationary pressures together.

Popular Revolution – The Possible Contagion Effects

Political developments in the Middle East generate the obvious concerns regarding oil prices, but there are much wider implications. Will the seeds of popular revolution spread further afield in the Middle East, and even further to parts of Asia, Africa, Latin America, all regions that have more than their share of repressive, autocratic regimes?

Even in the US there is a swelling of popular anger at states and municipalities forcing through fiscal austerity measures. Many states and municipalities are, to all normal purposes, bust, and if they were a company would be facing, or already in, Chapter 11 bankruptcy protection.

Fiscal austerity is also bringing the people out into the streets in parts of the Eurozone. Ireland, for example, has just seen the incumbent regime booted out in no uncertain terms.

What does all this mean for economics generally, bond markets and job markets? What does it mean for global capital flows? Recent weeks have certainly seen a reversal of flows to emerging markets which were the darlings of the global investment universe last year.


After all is said and done, we still need to make investment decisions in a world of great uncertainty. Ideally it would be great to find investments that will work well under either broad economic/inflation scenario.


Herewith a Summary of Investment Thoughts

Back to cyclicals globally: Under either economic scenario emerging markets, particularly Asia, are likely to enjoy relatively (or absolutely!) high economic growth. In the short term at least, there is a case globally (developed and developing markets) for rebalancing portfolios with more focus now on cyclical stocks that may benefit from stronger global growth.

North Asia over South Asia right now: In keeping with this theme, north Asian markets tend to do better than south Asian markets in an environment where the global Leading Economic Indicator is trending to the upside. It is in a bottoming formation right now and looks poised to move back to the upside. So a rebalancing of weight within Asia more to north Asian markets of Korea, Taiwan, China and even Japan is warranted.

These markets are generally cheaper right now than south Asian markets.

Domestic consumption plays shift to exporters: Stock selection focus in Asia near term should shift more to exporters again, from being very much more domestic consumption focused in the past year or so in Asia and other emerging markets. Global inflationary pressures can also in time reward exporters through an ability to increase prices and margins, something that is very difficult in a deflationary, low growth environment. This however may be offset in the early stages by rising input costs, something that has been evident in the recent results of many S&P 500 cyclical stocks.

Hard assets – commodities, both hard and soft: As a hedge against either broad economic/inflation outcome, maintain decent weightings in hard assets such as natural resources, commodities, including agricultural. In an environment of economic recovery, demand for commodities should stay firm with some potential for prices remaining to the upside. If global economic recovery falters, many emerging markets will continue to post relatively high domestically led growth, maintaining solid demand for basic commodities. Such countries will also likely use surpluses to encourage domestic consumption including infra-structure spending in such circumstances. Moreover, if western economic growth falters, central banks will continue with easy monetary policies and money printing. Such conditions push investment towards hard assets, and particularly gold. Maintain exposure to gold.

Secular demand for protein: In either economic scenario the stronger relative growth of emerging markets will continue to underpin rising demand for protein and other agricultural products. Prices of such products may well be underpinned longer term by these secular trends.

Angles in bonds: If inflation remains a concern, part of a bond portfolio might be allocated to inflation-linked bonds. However, these have pushed higher recently in most markets on the back of inflationary pressures. A linked strategy should be to focus on corporate bonds that could benefit from an improvement in company prospects and reduced risk on the corporate debt front.

Emerging secular high growth industries: Focus on industries that are structurally emerging sectors standing to produce higher growth on a sustainable basis under either economic scenario. Such industries include environmental services and products, alternative energy, skilled services industries (such as IT, engineering, medical services), food production and food related technology, health and education services. Emerging markets are likely to produce the lion‘s share of companies able to produce earnings growth rates at the high end of the range for longer periods of time

More Hard Assets – Asian housing – a 67 billion sq ft opportunity: In an earlier newsletter we identified that Asian rural-urban migration will produce incremental demand for housing for about 295 million people in the larger population countries in Asia alone (not including Latin America, Africa and Eastern Europe), which we estimate will require building some 6.7 billion sq m of residential space (67 billion sq ft) over the next ten years. At present many governments are responding to surges in prices of urban housing with an array of initiatives intended curb rising asset prices. For the time being, stocks involved in this industry have been adversely affected in most Asian markets, but the long term growth prospects are very substantial and companies stand to enjoy relatively high rates of growth over sustained time periods in markets such as China, India and Indonesia. At present residential developer stocks in such markets are cheap in relation to their longer term growth prospects, but government property cooling initiatives are causing investor nervousness in the sector.

Secular growth trend in office space demand: Demand for commercial space in major cities in emerging markets will increase sharply over the coming decade as service industries develop from a low base. We calculate in the core large population countries in Asia that there will be a demand for some 230 million sq m (2.5 billion sq ft) of new office space in the major cities in the coming 10 years. This sector is currently not under government pressures to moderate property price increases. Again major property investment companies and commercial property focused REITs stand to generate high levels of asset growth and rental income over a sustained period.

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