Consumers will drive the coming inflation

Consumers, supported by government largesse, will drive the inflation forward. Consumer spending will be supported by government deficit spending across Welfare, handouts, etc.

Consider the above chart, for larger version where consumer is broken out. True consumers are looking for better pricing – but, where do lower consumer prices originate from?

Lower consumer prices originate from increased productivity. Higher productivity results in a higher supply of goods and services. The higher supply, drives lower prices, as demand on aggregate stays fairly constant, only growing over time. The data shows that consumer demand certainly took a serious hit during the crisis, however, consumption never sleeps, and is once again turning upwards.

The credit crisis, has damaged production. Banks when they create credit, primarily create inflation within producer prices, only later do producer prices spill over into consumer prices as all producers are forced to raise prices to maintain margins.

Lets take cars, a doomed industry if there ever was one, as an example:

As for an example of where the inflation component of stagflation may emanate from, we can look at a recent Bloomberg story headlined “Buying a car gets pricier as GM, Ford cut inventory.” According to the story, which cites J.D. Power and Associates, “U.S. automakers’ vehicles sold for an average of $2,000 more in the second quarter than a year earlier.”

Now why would this be the case?

If we look at the inventory overhang, we can see that it is reducing, and reducing quickly. There were most likely bargains to be had when the inventory overhang was at its most severe, but now, they are gone.

Also gone is the ability to create levels of supply to replace that inventory.

Manufacturing capacity has fallen due to massive liquidations of capital. This liquidation of capital was forced on the manufacturing capacity by the withdrawal of credit from the banking system.

Capital goods, the tools [capital] required in the manufacturing process wear out, function less efficiently, and constantly require renewing/repair to maintain the productive capabilities. With the withdrawal of capital via the credit markets, productive capital is not being renewed/replaced. What capital that is not fixed, but variable, will be moved closer to final consumer demand.

Capacity utilisation, a measure of redundant fixed capital, reiterates that manufacturing capability has fallen substantively. Without the renewed investment within capital goods, or variable capital, fixed capital, plant & land, become redundant and ineffectual. Consumer demand, maintained and amplified via government monetary & fiscal policy, will soon outstrip the ability of the manufacturing base to provide the supply.

The resultant higher prices, increase the profit margins available closer to final demand, thus attracting capital, again, to the wrong place. Government will once again drive malinvestment.

Due to low [ultra-low] interest rates, the PV of capital, which is represented by the components of the stockmarket, will continue to rise in value. Labour, which due to the exactly same mechanism, has low PV, hence, unemployment will continue to rise.

Once the inflation takes hold, and the Federal Reserve either voluntarily, or forced, start to increase interest rates to offset or combat the inflation, then, once again, we will see a falling stockmarket, that will take the index back into a low P/E environment. This will be the last leg down of the 2000 secular bear market. Once valuations for the S&P500 hit circa P/E 7.0 once again will a buy & hold strategy make sense as a new secular bull market unfolds.