Global inflation

I always have a lot of questions. Here is one. The commodity price has been rising in the past years. There are in general two types of commodities. One is natural resources, the other is agricultural products. In the past years, they all rose. People also talk about global inflation from this price behavior. The question in my mind is will we get a global inflation because of that? In the long run, I am almost sure to say no. inflation is driven by money growth. That is it.

We learnt two important lessons in the past. One is the great depression in 1930s and the hyperinflation in the 1970s shows that money growth is the major reason for inflation/deflation. Two is the 1980 and 1990s shows that inflation can be driven by not only money growth, but also inflation expectation. These two lessons, may be together with globalization, leads to a stable inflation in the past years. If money growth is stable, and if central banks are able to stabilize inflation expectation, inflation should be low and stable as well.

Back to the commodity price story, the rise in natural resource like oil, copper, etc. should have a very different dynamic than agricultural products. Thanks for China and India, both are driven by increase in demand in the past. The big difference is that the supply of natural resource is fixed in the short run, which is constrained by the discovered quantity underground. The only adjustment comes from price. However, agricultural product is more flexible in supply. Farmers can switch to different types of crops when the demand is high. I recently read the story about the hardship of California farmers faced this winter (due to cold weather) is a boon in Florida farmers. Furthermore, the substitution can exist not only within countries, but across countries. There is hardly a monopoly like the OPEC in oil sector. I am not claiming it is an overnight process, but it is way more flexible than natural resources. The price adjustment will be complemented by quantity adjustment.

What does that mean for a rising global demand? The hypothesis has been there for quite a while. China has been in strong growth since 2000. Average growth rate from 2000 to 2006 was more than 8% annually.

For agricultural product, with more flexibility, farmers should well establish the expectation of rising global agricultural demand for quite a long time. And because of this, their production layout should be smoothly adjusted accordingly. In particular, when the farmers know the demand for crop A is going to rise, they expect its price should rise in the future. They should save some of the output for a while, this leads to a rise in the current price. Or they just charge the price higher today, otherwise they will save for tomorrow. Even if the storage technology constrains them to save for long, they may already prepare to increase the capacity of production once the rising demand hits. What it means global demand for agricultural product may drive the price higher, but the duration should not be too long.

Of course, agricultural price is moving ups and downs all the times. As people argued, which I agree, is mostly driven by local conditions, not global.

Needless to say, the price can be driven by unexpected event like a hurricane or a trade sanction. But again, the former is a one time event. The central bank’s job is to stabilize inflation expectation, that is it. Once the expectation is anchored, inflation dynamic will be stabilized fairly quickly. The latter is more politic than economics, which will be left to politicians and interest groups to play out. The sad news is a recent Bloomberg article shows that:

41 percent [of Americans] agreed that free trade has hurt the economy, versus 28 percent who said it's helped....Public sentiment on trade has reversed from 10 years ago, when almost 4 in 10 Americans said it helped the economy and 3 in 10 said it hurt.