Monday, 9 February 2009

The Humming Engine Of Inflation

At a recent meeting I was asked about inflationary forces present in the current economy. The question took me aback a little because most conversations about the economy at present tend to focus on an absence of liquidity, the threat of unemployment, and the significant reductions in world trade from which we are currently suffering. The short and easy answer to the question about inflation would have been that there are few inflationary pressures at the moment. To the contrary, the problem might be one of deflation rather than inflation. This, however, would have been the wrong answer.

There is currently a situation of contango in the global oil markets – an inverted price curve where the future price of oil is higher than the current price of oil. For example, the spot price of oil is currently about $40 a barrel and the 5 year price of oil is currently about $80 a barrel. If we have a discount rate of, say, 5%, the 5 year price should be about $32 a barrel (i.e. something costing $40 in 2014 has a present value of $32). This presages a steep rise in the price of fuel in the coming years. Looking at the question the other way around, a 5 year price of $80 a barrel now implies a spot price of $102 in 2014, at a 5% discount rate. In many ways, this takes on an aspect of Peak Oil – a point at which the oil will be worth more in the ground than in use, but it also serves as a reminder that inflation is a feature with which we will have to deal in the medium term.

This thinking has been reinforced in other areas recently. Since the meeting, I have been noticing petrol prices at the pump. Over the last four weeks, petrol has increased in price by 1p per litre per week, from 82.9p per litre to 86.9p per litre. This may partially reflect increased demand for oil products over the recent cold snap, but what is significant is that the price of petrol has increased by 5%, almost un-noticed, in a month. This increase may or may not fall back again. However, if our hypothesis is correct, it may indicate that recession induced price drops may have found their bottom.

Just as I was mulling this over, we received our January gas bill (for domestic natural gas). This quarter, the bill was £576, which I thought was rather a steep increase. Looking back, our January gas bills were £306 in 2005, £339 in 2006, and £430 in 2007. At this point, we restructured our household heating to use alternative sources – electricity powered radiators and a log fire – so that our 2008 bill came down to £342. This year, we are using fewer cubic metres of gas, but our bill rose by 68%. I see a pattern emerging.

We previously wrote about some of the long term pressures in the global economy that were helping to drive long term inflation (see post). These pressures haven’t gone away. The UN estimates global population to have been about 6 billion in 2000, and forecasts the global population to be about 8 billion in 2025. That’s an awful lot of additional people to feed. It is small wonder that the pressure on global food prices is upwards. These extra people all need to be economically active, which is placing pressure on limited supplies of energy resources. Together, food and energy inflation are likely to be a dominant feature of our longer term future, irrespective of how loose the markets are presently.

Of course, we have not mentioned the third element of the possible global inflation – water – because, in the West, we tend to take our water for granted. If the alarmists are right and the quest for drinking water causes displacement of populations and outright conflict (it has been suggested that the incursion into the Lebanon by Israel in 2006 was about who should dominate the Litani watershed – the first ‘Water War’ of the century), then the ‘price’ of that commodity is bound to increase and to have a second order effect on inflation in the West.

This brings us back to our model of scarcity for the first half of this century. Where are the inflationary pressures? In the FEW – Food, Energy, and Water. Actually, I would add minerals to that list, but it doesn’t then have such a catchy name. Whilst the short term pressure on these prices is downwards, the longer term outlook is a little more worrying. Just to make matters worse, the monetary authorities around the world are pumping liquidity into the financial system. If they do not mop it up just as quickly when the recovery starts, then they may well be fuelling the next inflation.

Whilst not driving forward at the moment, the engine of inflation is still humming away in the background.

© The European Futures Observatory 2009

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