Why Inflation is the Economy's "Iceberg" in 2013

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Even though Ben Bernanke's Fed has kept interest rates close to zero, inflation hasn't been a big problem since the 2008 financial crisis.

Despite what many observers have expected inflation has remained quite tame.

However in 2013, that may be about to change. One factor that might cause a surge in inflation is the fiscal cliff.

That's because Bernanke is already buying $1 trillion of Treasury and housing agency bonds each year ($85 billion per month) against a budget deficit that is about the same level.

That means the inflow of funds to the economy from the Fed and the outflow of money to fund the government's spending are about balanced.

However, if we go over the fiscal cliff the Federal deficit immediately falls to about $300 billion per annum. At that point, Bernanke would be injecting an extra $700 billion a year into the economy – which would have a corresponding inflationary effect.

The Case for Higher Inflation

But that's only part of the inflationary story.

Central banks around the world are also expanding their money supply. China has become more expansive, the European Central Bank is buying bonds of the continent's dodgier governments and Britain like the United States is monetizing nearly all the debt it creates to fund its budget deficit.

The big change in 2013 is now in Japan, where the new Abe government has told the Bank of Japan it wants much more buying of government bonds, to push the inflation rate up to 2%.

And just as Bernanke's money creation increases inflation internationally, Japan's new monetary push creation will likely increase inflation here in the United States.

In this case, theexcess money creation will get transmitted to inflation mostly through commodity prices.

The Thomson Reuters/Jeffries CRB Continuous Commodity Index closed recently at just over 300, about double its value ten years ago. And after a period of weakness in 2011-12, the index has recently showed renewed strength.

Now I admit, doubling in ten years may not sound very impressive, but that's a rate of increase of 7% per annum. It only follows that if the basic elements of everything we consume are increasing in price at 7% per annum, then impossible to believe prices overall will rise by only 2% in the future.

In one respect, we've been lucky when it comes to natural gas prices. Thanks to new "fracking" techniques the U.S. natural gas prices have been cut in half over in the last four years.

This has given both consumers and producers a boost, and kept inflation down. But the bad news is that natural gas prices appear to have bottomed out around April 2012, and are now well above their low. Going into 2013, higher natural gas prices may well be inflationary as well on the commodities side.

Why You Can't Trust the Inflation Figures

An additional factor tending to increase inflation is the tendency of official statistics to under-report it. This has not gone as far as in Argentina, where real inflation runs around 30% while official figures report inflation of 10%. Still, the official U.S. price indexes have since 1996 been distorted by "hedonic" prices, which adjusts prices downwards for the supposed "hedonic" advantage of chip capacity and speed enhancements in the tech sector. The effect of this appears to be about 1% a year, and it can be adjusted for.

However, a second fudge is about to be introduced. It's the "chain weighted" price indexes that both political sides have agreed to use to calculate social security and other payments.

The problem with chain weighting is that it assumes that consumers change their consumption patterns optimally according to price movements. In practice, actual human consumers cannot do this because they do not know in advance what relative price movements are coming. If they did it would be the equivalent of a ballplayer batting 1.000.

Here's why. ..

Consider an economy with two substitutable products-call them widgets and grommets. Initially both have the same price, but everyone buys widgets, which are slightly superior.

Then let's assume the price of widgets doubles in year 1. Everyone may switch to grommets, but these have not increased in price, and so the chain-weighted price index remains static.

Then in year 2, let's say the price of grommets doubles while that of widgets remains at the new higher level – so everyone switches back to widgets. But since these have not risen in price in year 2, the chain-weighted price index again remains constant.

So after 2 years, the prices of widgets and grommets have both doubled, but the price index hasn't moved at all. As I said, chain-weighting is a nothing more than a government fiddle.

The bottom line is that there's a substantial chance of a sudden upsurge in inflation in 2013, though the government statistics may reflect it only very grudgingly.

That will increase the costs of everything we buy, whatever the official statistics say.

As investors, we should avoid long-term bonds (even Treasury Inflation Protected Securities, which work off the official fudged price index) and keep a substantial portion of our wealth in gold and silver.

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  1. andrew popichak | December 31, 2012

    working in the auto supply/repair industry, our labor rate has gone from $75 per hour to $90 in 5 years, batteries that sold for $50 sell for $75 and tires average $10-$20 more than just a couple of years ago.

    • Rob Greene (@RGRundeRGRound) | December 31, 2012

      20% Labor Rate Increase
      50% Materials/Parts Price Increase (commodities)
      ~5% Tires (MFG Goods Price Increase) Mostly due to layoffs, productivity/efficiency increases, and maybe some stimulus to certain industries.

      Andrew, have your wages kept pace with ANY of these? Maybe the last, (5%?) but taxes/fees/costs are going up FASTER. I bet your PAYCHECK got very little to NONE of the Shop Rate Increase. :(

  2. John J Ciulla | December 31, 2012

    With all the monetary fiddeling going on globally, it is inevitable that inflation and possibly hyperinflation will rear it's ugly heads.
    As far as higher prices are concerned, they are already here and our devaluing dollars will continue to give us less bang for our buck.
    As the dollar declines in purchasing power, the price for silver and gold will increase and thereby act as a hedge against the destruction of all fiat currencies and preserve the wealth of those who have the foresight to own some.

    • Werner Weidner | December 31, 2012

      You are right on the button. Your Analysis is correct and when (not if) hyberinflation will arrive there will be catastrophic events following. Since the money which the US is owing will never be repaid in the normal way, there is the usual solution – WW3. I hope I am wrong.

      • DD | December 31, 2012

        If WWIII comes about, I guess we can blame this country for all the destruction it will bring due to the US's attempt in leveling the playing field in the hopes of coming out on top. Yes, the playing field will get leveled, but the US and her puppet countries sure as Hell will not come out on top.

    • r slimmond | December 31, 2012

      the price of gold and silver will not rise until the ongoing manipulation of the gold and silver price,orchestrated by the FED,is stopped.This is a manipulation to the DOWNSIDE 1n both metals.The conductor is the FED and the players are thebullion banks.Look at the monstrous, ILLEGAL and continuing SHORT position held by these banks,particularlyJ P MORGAN in silver.What are you AMERICANS going to do about an ongoing CRIME IN PROGRESS.Acrime that is being ignored and winked through by the CFTC and CME who are supposed to protect you.

    • hangemhi | December 31, 2012

      wrong, wrong and wrong. Declining value of the dollar will lead to greater trade for the US. But of course everyone else is devaluing too so it is a wash. The gold rush is over and the chance of hyperinflation is exactly zero. The total misunderstanding of what monetary policy does and doesn't do will allow gold to levitate for a while, but as people wake up to the realization that Fed "printing" is merely an intra-bank phenomenon that doesn't make it into the real economy, gold is going down. I'd be happy to bet your soon to be worthless dollars, but as most hyperinflationists, you'll just keep saying "next year" until we're both dead and gone.

      • david | December 31, 2012

        gold does good in inflation and deflation….gold is used when governments are acting irresponsibly with our money,ZIRP and NIRP are irresonsible…at some point the fed balance sheet as well as the rest of world will have to unwind.Your ignorance will destroy you as you must see the hegemony of the petro dollar status is on the way out.See what happens when fiat gets to its inherent value.Inflation is an effect and is purposeful for banana republics or they default.Who will bail out The petro dollar????why did the queen have to walk through gold vaults in a propaganda stunt…???Why are central banks gobbling it up?Finally, negative real interest rates are always bullish for physical bullion as no lost opportunity cost.Return of capital more important these days than return on capital.Thats enough for now,hangemhi.

      • Jack | January 1, 2013

        Very interesting comment, I have a tendency to agree with you, because things never seem to change they just limp along. The money printing never reaches the people either. As I conduct business with customers, they never seem to have any cash. when I tell people the printed money never gets to this level they think I am crazy. You seem to understand that theory ,would you care to elaborate?
        Jack

        • Alan | January 2, 2013

          The printed money usually winds up in the savings accounts of the big banks (as what happened with TARP). This can only go on for so long before the money makes its way into the market. If we had allowed the banks to fail and used the TARP money for public recovery programs for homeowners that lost their properties, we would be in a different position now.

          Instead we have fed the savings accounts of the big banks to hold their bad inventories with TARP. Now, we are in QE infinity and beyond. This isn't sustainable. We are still operating on a deficit. Any small business would be sunk if they operated like this. This can't last and it has reached a breaking point. I believe the next two years will be the most revealing.

      • PHILIP GOLDMAN | January 6, 2013

        DOLLAR UP…METALS DOWN…WHEN DOLLAR REACHES TOP & BEGINS A DOWNWARD TREND…HYPERINFLATION BEGINS…PERIOD

  3. Rob Greene (@RGRundeRGRound) | December 31, 2012

    So this widget/grommet example's Fallacious Fudge Factor is the year to year RESET.
    If prices on a deleted factor rose mostly in Year 1 (or 2008) The item was deleted from the
    scoring. Then, after 2010, the other item was deleted because of demand driving up the price,
    so we switch back to the first item which has had a fairly level year in terms of inflation, and only
    look at it's prior year (2010) because it was nearly level. Instead of keeping a running total >:-(

    Devious, Disingenuous, Diabolical.

    One administration will introduce a new trick or lie, and the next will exploit it TO THE MAX!

  4. Clarence Brown | December 31, 2012

    This financial train wreck has been coming for decades. Governmens (local,state,and federal) have been cutting and rearranging deck chairs for awhile now to keep the economy looking better than it is. Even breaking laws and going around our Constitution to do so. One of Americas biggest engineered problems is the lack of education. If you can't see and understand it you don;t care about it.
    I ask people "just how are they going to pay off a sixteen (and growing) trillion dollar debt" ??
    Monetizing our debt and labeling a lot of spending as emergancy, or disaster funding doesn't help either. We are past the point of an easy fix or correction to this crisis. Excess government spending will not stop. Most people don't understand what the ramifications of our government over spending and mismanagement will mean to their own well being and financial situations. it will not be pretty in five or ten years.

  5. Martin | December 31, 2012

    Thanks for the chain-weighting explanation. Seems criminal to me. But on the other hand I cannot agree that "Bernanke's money creation increases inflation internationally". Not necessarily – not yet at least. He's been at it for some time and yet inflation (internationally, too) has generally remained moderate, because folks aren't spending…because they have run out of money. Bernanke cannot induce wage inflation and higher employment because of the state of the economy. So low inflation will be around for quite a while yet.

  6. dan byrnes | December 31, 2012

    So why is the feds making 300,000,000.00 billion in cash are the rich pulling there money out of are system?

  7. hangemhi | December 31, 2012

    Ugh, I couldn't get past the first paragraph. You think less gov spending (lower deficits) will cause inflation???? LOL. When will obviously broke authors who can't make a buck elsewhere realize why they're so bad at predictions? And that QE and Fed policy is only good for causing lower interest rates and virtually nothing else? That QE does not get new money injected into the real economy?

    The bottom line, if deficits decline, so will the economy no matter what the Fed does. The ONLY chance of Fed induced inflation is if banks see a housing recovery and relax lending standards. This appears to already be happening, and the positive feedback loop could replicate the last bubble. But if we go over the fiscal cliff, and deficits decline, that will lead to deflation, not inflation, no matter what the Fed does because they ARE NOT injecting that money directly into the economy – there is virtually zero transmission mechanism – like throwing a pebble into the ocean. Yet you think its a boulder being throw into a kids swimming pool. Sad

    • Jeff Pluim | December 31, 2012

      Wow, hangemhi, you had best take a look at your history books. When I read your first post I thought that you had no understanding of international economics but this last post just proves it. Take a good look at the country of Germany prior to WWII. Of course you can have hyper-inflation and not increase government spending, if you just keep printing money and pumping it into the economy. When there is little or no value for the bucks that are being printed, hyper-inflation ensues. As for Martin's credentials, he is not just some author. Check out his credentials. This guy has directed entire governments from the pits of economic kaos to smooth sailing. You must be new to this blog to not undedrstand that.

    • david | December 31, 2012

      You hangemhi think the world is only the ussa????its a global world.We are currently in a currency war globally.Ask Germany,China,japan,Brazil,australia,europe etc. currency wars lead to real wars.Also every liquidity crisis(2008) ENDS IN A SOVEREIGN DEBT CRISIS.fED BOXED IN CORNER….sO DEFLATION MEANS PRINT AND EVENTUALLY IT WILL LEAK INTO SYSTEM. AS YOU BELIEVE HOUSING IMPROVING ???yOUR NUTS…sEE FANNIE,FREDDIE,FHA??fasb SAVED THE BANKS…MARK TO MODEL NOT MARKET.cAN YOU SAY SHADOW INVENTORY????yOUR ARGUMENT IS LIKE WHOSE BETTER ThE REPUBS OR DEMS…NEITHER…YOU MAKE IT DEFLATION VS INFLATION…WHO CARES..aRE WAGES UP?ARE JOBS UP,IS ARE COUNTRY UP?tHIS FIAT EXPERIMENT IS ENDING A SLOW DEATH WITH tptb KICKING AND SCREAMING TO MAINTAIN THE LIE AND THEIR JOB….CALLED NO POLITICAL WILL.

    • Alan | January 2, 2013

      We have already been in a long period of deflation if you look at the FED's own numbers. You will see a spike here and there, but the overall trend is deflation since 08 due to people being afraid and paying off their debts instead of retail spending.

      Usually inflation spikes follow deflation periods like this.

      ANY deficit (not just lowering the deficit) will HELP to cause inflation which is a number of factors that combine.

      You are correct when you say if deficits decline so will the economy. This is how a debt based economy operates. But what you don't seem to realize is that a debt based economy is doomed to fail eventually. Sure you can creatively delay the inevitable, but the inevitable will come in a totally debt based economy. In our case we have been delaying this for 45 years or so and now the cracks have formed and we are seeing all kinds of problems.

  8. dourdan | December 31, 2012

    I say deflation

  9. Jacobo Medina | December 31, 2012

    With or without the cliff..difficult times await for the population of all ages..the ceiling limit might be hit tonight and the scary thing is that the goverment will need an icrease of at least 3 T to balance the spending cuts agaisnt the need of jobs creation and fund the fundamental programs on health care reform,quality education and rebuild old infrastructure to get the economy to start moving…any short term measure like the farmers bill extension and the EI due date to stop paying the unemployed workers is like putting a patch or bandaid to a patient's wound.The problem is so big and complex that any sound solution will take many many years to fix it..probably a whole generation but it requires big sacrifice from everybody specially from the wealthy if the really love this country and this is a challenging time for them to demonstrate that they do care for their home country where they found the opportunity to enjoy a high life style with no worries about money.

  10. H. Craig Bradley | December 31, 2012

    PICK YOUR POISON

    Given what America is likely to face at home we might be much better off suffering a nuclear attack ( hyperinflation, reduction in basic constitutional liberties, increased govt. surveillence and warrantless evesdropping, stagnant to decreasing standards of living, much higher taxes, less govt. services in return, higher crime, particularly in the suburbs, (See WSJ online, December 30, 2012: "Crime Migrates to Suburbs.")

    At least with a over nuclear attack, the suffering would be short lived for anyone near the blast zone. In contrast, the financial, monetary, and economic decline will be drawn out with plenty of discomfort and even pain to go around for a long time to come.

  11. Andy Schuck | December 31, 2012

    ANYONE who believes the official government number on the inflation % is an idiot.

    And what index would not include the price of fuel and food, the biggest contributors to inflation since people pretty HAVE to have both?

  12. ctb | December 31, 2012

    It is a shame that most people, including educated and executives, believe anything that they are told if repeated long enough. Take job creation by the wealthy if given continuing tax breaks/welfare/tax stamps. History and data do not support such claims. Every one is entitled to their own opionion, but not to their own facts. Nature has a self cleansing mechanism and it has engaged in self cleaning that can not be stopped and/or reversed until it runs its course. It is called natural cycles that in some cases can be postponed, but never avoided. Ignore natural cycles at your own peril.

  13. sirandrew | January 6, 2013

    I am confused .
    If the annual deficit is over a trillion dollars and the fed prints money to buy a good portion of this to cover deficit can I assume that the government is pumping around a trillion dollars by spending more than it receives in revenue a year into the economy ?The Fed, to cover this deficit, is printing the dollars without value to compete for goods and services and ERGO !,inflation.

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