Why inflation will rise.

Earlier, I posted the most recent University of Michigan survey on US inflationary expectations. The number has recently ticked sharply upwards, indicating that people expect prices to rise.

Almost as soon as the post was completed, I received the following comment:

What sector of the economy has pricing power outside of the light ammo industry? Has the spare capacity or supply been used up in the housing market, commercial real estate market, auto manufacturing plants, existing autos (we have far more than we need on the road already), or the financial industry (which should be shrinking far fast than it is)?

UMI must be surveying economists or other such idiots.

It is a fair question that deserves an anwer.

Recessons have a well understood dynamic pattern. The process starts with a fall in aggregate demand. Firms begin to accumulate inventories, a sure sign that a recession has begun. Initally, firms will be reluctant to fire valuable workers with their firm specific skills. This is called labour hoarding. However, hoarding, rising inventories, and declining sales put enormous financial strain on companies, particularly badly run ones. Revenues are falling, but costs remain high. Eventually, firms start firing workers, while weaker businesses go bankrupt.

During the early stage of a recession, there is significant downward pressure on prices. Faced with those huge stockpiles of unsold goods, firms discount heavily and inflation comes down. The discounting does the trick insofar as firms empty out their warehouses. It does little to promote growth or stabilize employment.

When the recession really begins to hold, two conflicting pressures emerge. On the one hand, as firms go bust, the supply side contracts and supply chains are disrupted. firms go bust, the supply side of the economy contracts, and supply chains are disrupted. If a factory closes, the spare capacity disappears completely. A bankrupted firm has no influence on prices at all.

On the other hand, unemployment continues to rise. Initially, people without work will run down savings, which will in part, sustain demand. Eventually, savings run out and demand will begin to suffer.

These two forces will fight it out as the recession matures. Eventually, firms will have reduced their inventories to a minimum, the discounting will stop stops, and profit margins will recover. At this point in the cycle, the downward pressure on prices abates. Inflation stabilizes, at a high level of unemployment.

Eventually, the lack of inventory, along with the disappearance of weak firms, and capacity contraints will create the basis for an economic recovery. The key message is from all of this is leave the private sector alone and it will sort the recession out by itself. It may take time, but growth will return.

However, the UK and US governments don't have the patience for natural self sustaining private sector led recovery. Instead, they want unproductive and wasteful public sector expenditure to sustain demand. They believe that governments can stabilize economies better than the market. It is an arrogant and conceited belief that has been repeatedly exposed by history. Nevertheless, politicians love intervening.

The Fed and the BoE have also joined the game. They have cut interest rates to almost zero and pumped out uncountable trillions into insolvent banks. In the case of the UK, the central bank is now actively financing the unsustainable fiscal deficit.

Of course, this policy activism has done nothing to support economic growth. Both economies have crashed, with GDP growth likely to fall by about 4-5 percent this year. More surprisingly, inflation, particularly in the UK, has proved to be rather sticky downwards. Insofar as inflation has fallen, it has been due to falling commodity prices, particularly fuel.

However, the private sector is not totally stupid. When it considers the economic future; it sees three things; a collapsing supply side of the economy; a massive increase in wasteful public expenditure which will inevitably lead to higher taxes and a large dose of irresponsible monetary growth.

Will this lethal concoction cause inflation to increase next month; maybe; maybe not. Will it cause inflation to rise sharply in 2010? Absolutely; hence the April rise of inflationary expectations.