The Impact of Commodities Inflation and The Falling US Dollar
By Nils Marchant, Options21.

This is an edited version of an Options21 Market Briefing presentation first delivered on the 7th June, 2008. Fuel protests and food riots around the world call for an understanding of global commodities price inflation. It is important for investors and traders to analyse the events which underlie the news. Essentially, there are two major causes of the inflation which is now evident:- firstly, growing Chinese and other demand for those commodities; and secondly, expansion of the US money supply, which is behind the persistent decline in the value of the US dollar. But there are also many minor factors such as politically motivated moves towards ethanol which have only driven up corn prices causing the basic staple diet of much of South America to soar in price.

In the past, and in theory, inflation would generally lead to increased interest rates. Western central banks would raise interest rates because the threat of inflation is far more serious than an economic slowdown. Inflation thus was to be avoided at all cost. But in the US, not now: not anymore.

The US had been running ostensibly two conflicting policies. On the one hand, and in accordance with accepted central bank policy, they had been controlling inflation by increasing interest rates. But on the other hand the US has been and continues to increase money supply at an outrageous rate, which causes inflation. Raising interest rates in fact had to be abandoned for three reasons. Firstly, the Federal Reserve sought to inject short term liquidity to delay the effects of the credit crisis. Secondly, raising interest rates would now only accelerate the already entrenched US economic downturn. And thirdly, interest rates don’t really work that well anyway to control inflation.

But the real reason is that the US needs to devalue its currency to reduce the value of its debt and current account deficit. They seek to do so in a controlled manner to avoid a US dollar crash. If they devalue the US dollar, they don’t have to repay as much. (Which, by the way, doesn’t impress the Europeans, who have half a trillion or so of US dollar denominated debt.)

Increasing the money supply is a well calculated programme. They are increasing M3 – the measure of broad money supply – at over 15% pa. Unless there’s commensurate economic growth, all those extra US dollars flooding around push up prices. And because the US dollar is still the global reserve currency, those dollars go flooding around the whole world as petro-dollars and in other forms, through all commodities,

So: what will be the effects? Well, obviously global inflation. Probably very high inflation in the US. But, what exactly is inflation? Well, we need to define that.

Inflation is the expansion of the amount of currency or the number of dollars in an economic system. Rising prices are only a symptom of inflation and the oversupply of money. Generally when you oversupply the market with money, prices go up. Those lessons have been learned since Roman times, notably in Germany during the Weimar Republic. For those interested, there is a humorous work of fiction describing everyday life in the German hyper-inflationary environment. Read “The Black Obelisk” by Erich Maria Remarque. It might be timely to relearn some of those lessons from history.

President Robert Mugabe in Zimbabwe has thrown away those lessons of history by printing Zimbabwean dollars to maintain power. Inflation shifts poverty in one direction, and wealth and power in another. He doesn’t appear to care about the destructive side effects which destroy his nation’s economy. Is it better to be the supreme leader of a dying state, or a subordinate player in a healthy state?

The US has been trying to hide their monetary expansion activity in a number of ways. For a period they actually suspended the release of treasury M3 data, to hide the rate at which they are increasing the US dollar money supply. But the world is not so silly as to be fooled. Intelligent people such as those at websites like “shadowstats” managed to reconstruct M3 values from other data, so effectively the US couldn’t keep it secret. They have now resumed publication of M3.

It’s all a game of spin – the manipulation of perception.

Inflation is measured by the CPI. The US has dropped various basics from their measure of their CPI. They no longer count energy and food, because those items are not what they deem to be part of “core inflation”. Those items also happen to be shooting up in price, and everyone happens to need food and fuel. But the US consumer knows the CPI figures are wrong, seeing their groceries going up by 10% or so pa, and their fuel by even more. Their incomes don’t keep up, especially now with the economic downturn.

And the effect of all this? The effect is to transfer wealth from those whose salaries, savings and loans are denominated in the currency to those who own income producing assets. Inflation is theft by stealth. Inflation transfers wealth from savers and lenders to borrowers.

The US economy is a consumer economy. Eighty percent of US economic activity is consumption. That consumption is largely funded by debt. Much of the production and supply of consumer goods has been transferred from US factories to Chinese factories. The declining US dollar makes imported Chinese consumer goods cost more, further exacerbating US inflation.

A consumer economy relying on Chinese debt to buy Chinese goods is not strategically smart. The decline of the US dollar will have serious and permanent repercussions. The US and the west is becoming increasingly vulnerable to Chinese demands. The global economic and political power balance is shifting right before our very eyes. Learn Mandarin.

Weakening consumer purchasing power will mean that the consumer can no longer continue to buy goods of the same value. When consumers buy products of lesser value, they consume less, and the consumer economy shrinks. Even though US consumers will continue to spend the same dollar value, because of inflating prices, they actually buy less. Higher commodity prices therefore will continue to feed and further amplify the already established US economic downturn.

The economic downturn won’t only be in industries affected by higher oil and metal prices, such as the automotive industry. It’ll stretch further across the board. There will be a shift down from luxury spending to essential spending. People will still eat, but they’ll eat, travel, dress and live more frugally. Profitability will shift from the luxury consumption industries – higher quality hotels, restaurants, cars and fashions – to basic necessity consumption industries – the Wal-Mart’s.

Another side effect will be in transport. Railways are an extremely efficient way to move goods. A train needs only a couple of drivers to move thousands of tons of goods, and because of the very low friction of steel wheels on steel rails, with a minimal quantity of diesoline. You’ll see US railroad stocks have been rallying since the beginning of 2008.

Inflation transfers wealth from those whose savings are denominated in US dollars to the borrower. Countries whose currencies are pegged or tightly linked to the US dollar will find food, fuels and basic resources more expensive. Hence rice, corn and other food riots, and fuel protests.

China needs to secure basic resources. Each month, more than one million people are moving from a rural environment to cities. That all needs copper, steel, nickel, iron ore, oil and coal. While we in the west are reducing coal emissions, China is building a one Gigawatt coal burning power station every week or two. So China has to take increasingly strident action to secure the basic resources it requires. China has a significant US dollar surplus: over a trillion dollars, and rising rapidly. China desperately needs those commodities – not so much to manufacture consumer goods for the US, but for its own urban and industrial growth. China is not only playing at takeovers for Unocal, and the resource giants. They are very active throughout resource rich Africa and South America, giving aid to countries, or maybe at least to those in political power. Was it a renegade Chinese group who attempted to ship arms to President Mugabe? I don’t think they have renegade groups in China. Everything in China is tightly controlled by the central party, or committee.

One must ask why China has paid for the construction of a new presidential palace and ministry of foreign affairs in East Timor. I’m sure the wiring will come free! The tropics are an ideal environment for thousands of bugs. And why China and East Timor are expanding military exchanges. The Timor gap contains potentially vast amounts of oil and gas. China needs to play hard ball to secure its resources.

Since the second world war all oil has been traded in US dollars. Those petro-dollars helped maintain the status of the US dollar as the global reserve currency. Monopolizing that oil trade in US currency gave the US global economic might. But now, with the dollar falling, oil exporting nations have to increase the US dollar oil price just to maintain the value of their revenue. Therefore another side effect of expanding M3 and flooding the world with US dollars will be to accelerate the rate at which oil exporting nations will move to trade oil in other currencies, to break out from the US$ monopoly, and trade in Euros or Roubles. Or maybe even the Yuan. But ultimately, we could see the resurrection of a pan-Arabic gold backed Dinar – a currency linked to the value of gold, unlike our paper fiat currencies whose inherent value rests on our trust in the authorities to keep money supply scarce.

It was reported that only a matter of weeks before “Shock and Awe” in Iraq, Iraq had commenced writing oil contracts in Euros instead of US dollars. The rumblings against Iran may be in response to Iran’s establishment of their oil trading exchange which allows for contracts to be traded in currencies other than the US dollar.

In a sense, preservation of the US dollar monopoly on oil trade is a matter of vital national security for the US. Oil is one of the last supports which prop up the value of the US dollar. For the US has largely destroyed the value of its own currency from within.

The US can not play the weapons of mass destruction card again. The irony is that it can not do so even if Iran really does have weapons of mass destruction. Iran's president Mahmoud Ahmadinejad appears to have played his strategic cards better than the west.

In a nutshell, the flooding of the world with US dollars can only cause prices to rise. Whether it’s corn or oil is only a minor consideration. Everything traded in US dollars has to go up. Even transferring transport from oil based vehicles to electric vehicles will not solve the problem. All that can do is only partially shift price inflation from oil to copper and other metals used to make electric vehicles, but China already dominates demand for those materials. As long as Chinese demand continues to outstrip supply, and as long as the US continues to inflate broad money supply – M3 – these conditions will continue to worsen. Inflation in the US looks like it will increase further, and faster, causing the US dollar to lose further value correspondingly.

Copyright © 2008 Nils Marchant.