Comstock Partners, Inc.
A Reader's Question About Inflation
April 22, 2004
Question from a reader—I look forward to your weekly commentaries and have been in complete agreement with your cycle of deflation theory…but I am becoming less convinced that deflation can still become a concern. I am the supply chain directory for an electronics distribution company and have been fighting product line inflation, from both domestic and international suppliers, for the past 5 months. I am highly skeptical regarding the sustainability of the economic recovery—but facing daily price increases from my supply base and mounting internal pressure to anticipate continued inflation (forward-buying / stockpiling inventory) I am not as convinced about deflation as I was on 1/1/04.
We answered—Obviously the price pressures you see personally are real, and in last Thursday’s comment we mentioned some areas where prices are rising. However, the bond vigilantes have now returned and have forced the long bond rate up while the Fed is under pressure to raise rates sooner. This will choke an economy that is running out of stimulation. We therefore believe that inflation will run out of steam. China, a major source of the increase in commodity prices, is already tightening. We also note that commodity prices are now weakening and that cyclical stocks have been turning down. Either way, however, the stock market is likely to decline, and that is the major bet in our funds.
The March PPI results were released after we answered our reader. While the top-line results showed little inflationary pressures, core prices for crude materials continued to rise significantly. March core crude materials prices were up 2.7%, and, more importantly, the six-month annualized rate of increase was 51.6%. While these prices are only a small fraction of total business costs, a rise of this magnitude early in the pipeline is a serious concern. These are probably representative of the prices our reader is seeing.
Nevertheless, we believe that when any portion of these price increases begin to creep into final prices, the Fed will tighten monetary policy, or the bond vigilantes will do it for them. In view of the current high sensitivity of the economy and the markets to any interest rate hikes and the structural imbalances remaining from the previous bubble, we believe that such a change in policy will halt the economic recovery. In that case inflation would peak at a relatively low level, and the subsequent recession would be marked by deflation as debt repayment would then become a huge problem.
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