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Inflation Threat is Very Real

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By EScroogeJr
February 8, 2008

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Some folks like Nouriel Roubini claim that if the economy does slip into a recession, then there will be no inflation. I'm afraid that they are dramatically wrong.

What are the arguments of proponents of "stagdeflation"? They think that recession will lower the demand for all products from oil to lead-painted Chinese toys. To quote Roubini, "a fall in US and global aggregate demand, a slack in labor markets and a sharp fall in commodity prices following the US recession and the global slowdown will sharply reduce inflationary forces ahead, both in the US and across the world". Let's see if this is really likely to happen.

Food. Here the demand is growing exponentially. You have 1 billion Chinese and 1 billion Indians who are finally beginning to eat decent food and many of whom are finally beginning to eat. A US recession is not going to change that. If these countries recouple and lose a whole one percent of GDP growth, then maybe the exponent will change, say from 1.09 to 1.08, but it is still an exponential dependence. Besides, last year's increases have not yet worked their way into the system, meat and dairy products have to get more expensive even if grain prices stay fixed.

Oil. The story is largely the same. With or without recession, the number of cars will still be increasing exponentially, and our foreign friends Ahmadinejad, Putin and Chavez will remain no less friendly in 2008 than they were in 2007. Sure, our Chinese friends will supply increasing amounts of photovoltaic cells, but it will take at least 5 years before solar energy really begins to displace fossil fuels.

Manufactured goods. Yes, Wal-Mart and the likes will go their part of the way, but the salaries of Chinese workers will still increase another 10% and the Yuan will appreciate another 5%. I don't see much potential for the imports to become cheaper than they are now.

Health care. Not really discretionary. Recession or no recession, when your tooth aches, you drive to the dentist's, pledging to hand over your soul and the keys from your house if necessary. The population is getting older, and again, as you get closer to the grave, your health expenses grow exponentially, not linearly. Even if Hillary cracks down on HMOs (far less likely than HMOs cracking down on Hillary), the effects will not be felt until 2010.

Housing. Rents are going to increase, they have to increase in order for the government to fulfill its social contract with homeowners. Growing population and declining construction is the sure recipe for increasing rental rates. Until property values grow another 50%, state governments are not going to issue more permits just because more people are sleeping under the bridges. Even when more permits are issued, it will take another two years before the new houses are built. Meanwhile, every year 3 million new people are injected into the system, and the entire new inventory of rental vacancies (investment homes converted to rental properties) has been used up last year. I am hard-pressed to project rent increases below 5% this year and below 10% next year.

Money supply. Bush wants a budget deficit of $400 billion, which in case of a recession will turn out to be an underestimate. The money will come from the printing press. That's a 6% increase in M2 supply if the 400 billion lent to the government is the only new money that Bernanke is going to print. However, he is likely going to print much more. Where else will the banks get the money to refinance all those mortgages?

So, do you still agree with Roubini's opinion that "Inflation will soon become the last of the problems of central banks as a severe global growth slowdown gets underway."? My take is that we're going to have a 5% inflation in the conservative scenario, 6% in the realistic scenario and 7% or more in the pessimistic scenario, and these numbers may need to be revised upward if the recession which the market has taken for granted fails to materialize.