The Outlook For Inflation and the Likelihood of $60 Oil - Hussman Funds' Weekly Market Comment

Summary:
John P. Hussman believes speculators are behind the rising oil prices, and that the fact that speculators don't take physical delivery for the product is irrelevant. What matters is that the purchase of futures contracts by speculators is crowding out the purchase that a bona-fide hedgers would otherwise be able to make from a producer. In a few months, however, due to broadening economic weakness we may see an unwinding of speculative pressure, resulting in steep declines in commodities prices, including oil. On the topic of inflation, Hussman believes that a combination of weakening demand for most goods and services as a result of consumer restraint, accompanied by a generally firm demand for currency and Treasury securities as safe havens from credit risk will result in disinflation, rather than inflation. Excellent tutorial on the causes of inflation in terms of marginal utility, and how government spending (whether by printing money or issuing bonds) contributes to inflation. Government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities. (Published: 07/07/08)

Notes:

Inflation

• bulk of recent inflation has been restricted to food and energy
• year-over-year change in the CRB commodity index minus food and energy is already negative
• main factors influencing the outlook for broad inflation
• US economy most likely already in a recession
• consumers are unusually strapped because of both mortgage debt and high budget constraints
• international economies are beginning to weaken
• note: China: Shanghai index down by well over half since last year's peak
• stock markets typically don't drop in half without economic repercursions
  
• credit concerns are endemic
• US government spending: relatively stable and not expanding rapidly
• given this context:
• combination of weakening demand for most goods and services as a result of consumer restraint
• accompanied by a generally firm demand for currency and Treasury securities as safe havens from credit risk
• that combination is disinflationary
• likely that we'll observe further downward pressure on inflation outside of the food and energy groups over the coming quarters

Oil prices

• broadening economic weakness and an unwinding of speculative pressure will combine to produce steep declines in commodities prices
• most probably by the end of the summer season
• is the price of oil being driven up by hedge funds, commodity pools and speculators?
• many pundits say no:
• speculators don't take delivery of the physical product
• instead they roll their futures contracts over indefinitely or until they close out their positions
• so they can't drive up prices
• Hussman says yes:
  
• disagrees with opponents:
• argument ignores the zero-sum nature of the futures market
• producers have an interest in selling their output forward to lock in a predictable price
• similarly, bona-fide hedgers (e.g. transportation and industrial companies) have an interest in buying oil forward so they can plan without concern about future fluctuations
• speculation unbalanced on one side: purchase of futures contracts by speculators begins to crowd out the purchase that a hedger would otherwise be able to make from a producer
• doesn't matter that the speculator has no intent to take delivery
• if the speculators are unbalanced on one side, the producers will have satisfied their need to pledge future delivery
• and because they can lock in a high price, they will be inclined to sell more for future delivery than they otherwise would
• meanwhile, bona-fide hedgers will be inclined to buy less on the forward market than they otherwise would
• when it comes time for the speculators to roll the contracts forward, they have to sell their existing contracts either to someone who is willing to take delivery
• or to a producer who sold the oil forward and can now clear that liability without actually producing the stuff
• given relatively high spot demand and tight supply, these rolling transactions have worked fine to this point, without driving prices lower
• problem will emerge few months from now as
1. economic demand softens further
2. planned production hikes actually emerge
3. weakening price momentum encourages speculators to close long positions instead of rolling them forward
• at that point, we can expect the net speculative positions to plunge by 10-15% of open interest
• we'll see a sudden glut on the market for spot delivery
• should not be surprising if this speculative unwinding takes the crude below $60 a barrel by early next year
• geeks rule of thumb:
• "when you have to fit a sixth order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak"
• doesn't mean that prices can't move even higher over the short term
• once prices go into a vertical spike, very small changes in the date of the final peak imply significant uncertainty about the ultimate high
• but: reasonable to believe that the often extreme cyclicality of commodities has not suddenly become a thing of the past.

• In commodity markets in particular, price trends feed on themselves in both directions, so we see pronounced cyclicality, and much more persistent trends – once set in motion – than we typically do in the equity and bond markets. It may be difficult to identify a peak in oil when it occurs, but most likely, the fallout from that peak will be spectacular.

Primer on inflation

• concept of marginal utility
  
• ice cream: 1st ice cream very enjoyable, 2nd one a little less, ..., 4th one probably indifferent
• as you increase the availability of a good, the "marginal utility" declines
• i.e. the value you place on an additional unit
• same principle holds for economy as a whole
• e.g. economy-wide supply of ice cream and pencils
• marginal utility of ice cream: 6 smileys
• marginal utility of pencils: 2 smileys
• price of an ice cream cone, in terms of pencils = ratio of their marginal utilities = 3 pencils
• money
• dollar in your wallet
• you hold onto it in your wallet, forgoing interest earnings, because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth
• dollar provides certain amount of marginal utility
• as a result, the prices of goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between "stuff" and dollars
• i.e. the dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar
• how do you get inflation?
  
• either, increase the marginal utility of "stuff"
• happens either if the supply of goods and services becomes more scarce
• or if the demand for goods and services becomes more eager
• or, reduce the marginal utility of dollars
• happens either if the supply of dollars becomes more abundant
• or if the demand to hold dollars becomes weaker
• effect of government spending and fiscal policiy
  
• need to stop thinking in terms of "partial equilibrium"
• ie. supply and demand of one item at a time
• think instead in terms of a full or "general" equilibrium imposed by a government constraint
• government spending
• financed through printing paper
• happens in banana republics
• predictably leads to inflation
• in particularly unproductive economies, it leads to hyperinflation
• financed through issuing government bonds
• tempting to think that issuing bonds means that the government is taking something in return for what it spends
• whereas printing money means an increase in spending power
• but: important to focus on the general equilibrium
• regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper: a government liability
  
• in return, which has to be held by somebody
• both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment
• values of currency and government securities are not set independently of each other, but in tight competition
• particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night
• whatever the form of the paper receipts, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities
• real goods and services are being appropriated by government in return for an increasing supply of paper receipts
• setting a proper marginal tax policy
• on deflation
• e.g. Great Depression
• the marginal utility of “stuff” dropped, while the marginal utility of money soared
• output declined enormously
• but output fell because of a major reduction in demand
• so the marginal utility of goods and services most likely declined during that period even though production itself was down
• in contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency
• even the monetary growth that occurred wasn't nearly enough
• the frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money
• result was rapid price deflation

• Summary:
• inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money
• can reflect:
  
• supply constraints
• unsatisfied demand
• excessive growth of government liabilities
• or a reduction in the willingness of people to hold those liabilities
• inflation typically picks up in late-stage economic booms
• not because the economy is growing too fast, but rather because the economy begins to hit capacity constraints and is therefore not able to grow fast enough
• Fed often attempts to cool down the resulting increase in the marginal utility of goods and services
• by trying to make sure that demand growth doesn't outstrip the increasingly constrained level of supply
• apart from commodity prices, which may take a bit longer to reverse, the pressures on marginal utilities are presently on the disinflationary side

• Milton Friedman is widely known for two phrases
• "inflation is always and everywhere a monetary phenomenon."
  
• only half right because a government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities
• very true that the major hyperinflations in history have been triggered by currency expansion
• but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation
• "The burden of government is not measured by how much it taxes, but by how much it spends."
• completely correct