Friday, February 4, 2011

The Ten PM Tutorial vi: Exporting Inflation

With food prices rising in the rest of the world, sparking riots in Egypt and general social unrest in other countries, commentators have been talking about how the United States is “exporting inflation”.

It sounds confusing, but this is actually a simple concept.

The Federal Reserve has been printing money via Quantitative Easing (2008–09), QE-lite (August 2010–August 2011), and QE-2 (November 2010–June 2011). These policies have meant that the Fed has created money, then used it to buy toxic assets (QE-1), then Treasury bonds (lite and 2).

The reason the Fed did QE-1 was so that the toxic assets the American banks had on their balance sheets wouldn’t drive them broke—as they were threatening to do. When the Fed carried out QE-1, the banks got rid of their toxic assets, and got fresh money. They used this money to buy Treasury bonds.

When the Fed unleashed QE-lite and then QE-2, the Fed was worried about a deflationary spiral: Lower aggregate demand pushing prices of goods and services lower, forcing companies to lay off workers, which naturally curtails demand, pushing prices for goods and services lower still, and so on.

By flooding the economy with money via QE-lite and QE-2, prices of all asset classes would rise, thereby avoiding a deflationary death spiral.

This was a successful policy: There was no price deflation. Instead, markets have rallied: Stocks, bonds, commodities—

—and here’s the problem: Since late 2009, commodities of all classes—precious metals, industrial metals, oil, agro—have all been rising, and rising rather precipitously at that.

The rise in commodity prices in dollar terms has meant that foreign countries have to spend more dollars in order to import the same amount of a commodity, let’s say wheat. This rise in the price of wheat is passed on to the local population, in the form of higher prices for bread.

Since spending on food comprises a greater proportion of income in poor and developing countries than in richer countries, real-world inflation affects a population faster in poor and developing countries than in the U.S. or Europe.

Lately, we have been seeing this: The riots in Egypt were triggered by rises in food prices. Problems in Indonesia, Asia, Brazil. All food related.

Federal Reserve chairman Ben Bernanke claims that the rise in commodity prices has nothing to do with the various versions of QE—he claims instead that rising commodity prices is because of natural events curtailing commodity production (floods in Australia, drought in Argentina, fires in Russia) which of course makes prices rise, and is also a sign of a recovering economy, as stronger demand puts pressure on prices. Bernanke also claims that rising inflation in the developing world is a sign that those economies (China, India, Brazil, etc.) are leading the way out of this recession.

Bernanke’s explanation is pretty complicated, if you get right down to it. Apply Occam’s razor: The simpler explanation is that dollar creation by the Fed by way of the various QE’s has driven up commodities, whose price increase is being reflected in the rise of consumer goods in the poorer nations first.

Thus in order to “save” the U.S. economy, the Fed has “exported inflation” to the rest of the world.

The obvious problem, of course, is that this inflation won’t stay outside the U.S. for long. Like a boomerang, it’ll soon be coming back.


  1. John Hussman has been consistently critical of QE, warning us that Ben is playing with fire.

    His recent market commentary on October 18, 2010 - "The Recklessness of Quantitative Easing" did an EXCELLENT job of explaining why QE causes commodity prices to rise.

    -Dave in MO

  2. hmmm... ok. I was sorta tracking with you until you tried to apply Occam's razor and came up with QE being the simplest explanation for a a rise in prices vs. an increase in demand and a reduction of supply. To me, it doesn't get any simpler than that. Now adding in some of the thoughts of Hussman (granted, I didn't read his whole piece) you could argue that the reduction in supply is due to hoarding that was triggered by FED signals interpreted as inflationary. But in that case you have more of a self-fulfilling prophecy based on a predetermined view of what the FED signaled.
    Still, thanks for the explanation for the term of "exporting inflation." Seems almost fitting since we exported all the jobs already.

  3. I've read your post twice, to make sure I'm not missing something, but it explains commodity inflation in the U.S. Not how inflation is "exported". The currency of a nation with a freely floating exchange rate would appreciate, meaning the dollar price of wheat would not matter. Countries that manipulate their currency versus the dollar to maintain an export advantage (China, India, Egypt, and others) are going to "import" inflation. But that's their choice, not the fed's.

    There are two reasons commonly given for fed printing. The first is the official (and widely derided) reason - to restore economic growth. The second is the "real" reason, stated in your post - to bail out the banks. There may well be a third occult reason - to jam the gears of the Chinese export engine.

    I believe the global rise in commodity prices is much more complicated and multi-factored. I am not trying to defend the fed here.

  4. Dear GL;

    Your explanation makes sense for a foreign countries US dollar reserves.
    But even as that depreciates and prices rise in US dollars, these countries have their own currencies and other reserves that notionally, commodity prices should remain the same. Maybe the exception is oil priced in US dollars, but if I were buying wheat, wouldn't I choose to get a better deal using my stronger currency?? Also, for all the QE dilution, why doesn't it show up in DXY which is the USD FX rate measured against other currencies. Not trying to be contentious on this point, I am just curious.

    I have to go with Jeff Burton's take (above) -- that likely the situation is a hybrid combination of diluted US dollar, reduced aggregate supply, and increased aggregate demand. I think too we are not factoring EXPECTATIONS of the foregoing factors by speculators driving futures.

  5. This does not have to be complex, posters.

    Food is a fungible commodity (we all use it and for the most part: food can be traded and food can be shipped anywhere).

    Many investors are also bidding up the value of commodities based on what they see happening with the Fed.

    The Fed's actions do indeed affect the rest of the world. Fear is one of the greatest motivating emotions - both for investors who want to preserve their capital and for the poorer who don't want to starve.

    Maybe Americans have more trouble recognizing this because to a large extent we have our needs met and there is little fear.

    -Dave in MO

  6. Off topic a bit. Here is another question. James Turk from GATA has been addressing the topic of "silver being in backwardation." Is that something to be concerned about? Would that be the sort of activity that would suggest a extremely strong demand over supply for just future's contracts, and not the real world physical? Is backwardation of silver more of technical paper activity?

    Thanks from Kansas,Hope you are having a good weekend GL.

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  8. I think I get it. Inflation always hits hardest those whose cost of food and shelter is the highest percentage of their income, right? I had erroneously been expecting lots of inflation in the US with each QE, and not seeing any meaningful effect or our poorest citizens, just a vague tightening. Now I think I understand that I was defining the "fish-bowl" incorrectly; I thought I was living in a USA-fishbowl. But, since the US-Dollar is the World-Reserve currency, I must re-define my fish-bowl. That would mean the poorest countries would be the first to suffer from the rising inflation. So The Bernank can keep the QE hits coming and eventually less poor countries will start to really feel the pinch, right? Maybe he could stop just before the wealthiest Western-7 go broke... It's kind of like financial chemo-therapy; it's bad for all the cells (countries), but it's much more toxic to the cancer cells (poor countries) than it is for healthy cells (us)... Right? Right??? Oh hell, I still don't get it!

  9. Gonzalo,
    I'm not sure if this is related to the inflation topic, but would it be feasible to cover the topic of currency exchange as 10PM tutorial? I have no clue as to how the exchange rate of one currency is calculated vs another ... or is it just a BS manipulation game based on arbitrary factors?
    This is what's confusing me and why I bring this topic up - we keep harping about QE program basically multiplying the supply of US dollar "reserves" globally by 2X/3X/4X??? So we bash the US/Fed for this.
    At the same time, why are the exchange rates for the other currencies vs US dollar still relatively the same as before QE? For simplicity's sake, if USD$ vs Euro was 1:1 before QE, and QE effectively doubled USD$ reserve supply while Euro pretty much stayed the same (generous assumption), then why didn't the exchange rate adjust to 0.5:1 USD$ vs Euro?
    Are we unfairly bashing ONLY the Bernank? If the US is guilty of "Quantitative Easing", then on the flip side wouldn't the rest of the world be guilty of similarly manipulative "Quantitative Tightening"? Why haven't they allowed their respective currencies to strengthen in proportion to the USD$ dilution? (I'm guessing they are fucked because they hold such big reserves in USD$ and would be raping their own savings, they need to protect their export-driven economies, blah blah blah ... but any other reasons?)
    Wouldn't the cost of imported food be cheaper for them if their currencies strengthened against the dollar?
    Is this inflation crisis only due to the Bernank? Besides the US QE money flooding of trillions of dollars, I'm curious how much the rest of the world has also contributed by printing paper money through their own respective central banking schemes?

    ***US QE = $2 Trillion (or whatever the correct figure is over the past couple of years)
    ***Rest of World = ??? $ (maybe also pretty significant, but overshadowed by QE media coverage)

    I'm just trying to have some additional perspective that includes non-American financial/economist bastards and assholes (since every race/culture/nation) is equally adept at producing their own, right?
    Definitely not trying to defend the Bernank.


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