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Debating the Return of Inflation

Courtesy of Pacifica Partners

When the world's central banks decided to undertake a zero interest-rate policy and then to inject money into the global banking system to levels that were previously unforeseen, there was widespread fear that this would eventually unleash an inflationary firestorm.

Our take was, and is, that these worries were misplaced because the ability of the banking system to circulate or turnover this cash in the economy was broken. In the US, the velocity of money (the rate at which a dollar of bank deposits is able to circulate around the economy) is still dropping -- almost six years after the near meltdown of the financial system. We have been watching the tug-of-war between the inflation and deflation sides and maintained that sometimes we can have neither. So far, that is exactly what we have.

Up until just a few months ago, the prevailing argument from central banks and economists seemed to have shifted toward the view that there was not enough inflation and the further weakening of inflation would be a dangerous development. The poster boy of what can happen when inflation gets too low is Japan where policy makers have been trying to stoke inflation and get the economy moving for over 20 years.

Given recent data we are beginning to consider the possibility that inflationary pressures are starting to surface. Unfortunately, central banks may be poorly positioned to contain inflation if they choose to cling to zero interest-rate and inflationary monetary policies for too long.

Central bankers will reduce inflationary policies as they witness strength in their underlying economies by reducing bond buying and perhaps by raising interest rates. Recent economic data does indicate a firming in economic growth. In North America, labor data shows unemployment falling and simultaneously businesses are signaling their intent to raise wages. Another data point for assessing the strength of the labor market that often goes unreported is the number of people who are voluntarily quitting their jobs. Recent US data shows that the number of workers who feel confident enough to quit their job to find other employment is at the highest level in six years with April 2014 data showing 2.34 million people gave their employers a notice to quit.

While these are standard economic variables that most garden variety economic discussions encompass, we have been watching another factor that we think could begin to impact inflation in a more consistent manner. That factor is food prices.