This week’s note will begin by reiterating our bullish theme on the Natural Gas market. We hav...
Get Ready to Pay Up for Imports
04/20/2011 2:13 pm EST
The weaker dollar will saddle US consumers with mounting bills for everything from gas to groceries, writes Axel Merk of Merk Investments.
Should investors be concerned that a weaker US dollar causes inflation? The price at the gas pump should be a stark reminder that a weaker dollar may contribute to higher prices.
Yet economists tell us that food and energy inflation does not count. Why do economists have such a baffling sense of logic?
When Federal Reserve Chairman Ben Bernanke tells us a weak dollar is not inflationary, he truly means it. And he is right. But possibly also very wrong.
As a scholar, he bases his view on research conducted at the Fed. “Research” refers to a study of the past, with the argument that the past may be the best we can go by in assessing the future.
But Our Economic History Is Only 40 Years Old
Given that our current fiat monetary system has only been in place since Nixon removed the last link to the gold standard in 1971, one needs to consider that we have hardly had enough economic cycles to truly understand all levers that drive inflation and the US dollar. In a world inundated with data, economists are eager to find patterns to extrapolate.
Not surprisingly, I had to endure presentations by very smart Ph.D.’s in the years leading up to the financial crisis who argued that housing prices would never decline: just look at the data! It never happens, not in the US!
The missing piece in the analysis was common sense—but as we all know, it wasn’t just a few that were caught in this trap.
The reason Bernanke is right is because in the past, indeed, a weaker dollar has not necessarily been inflationary. Most notably, the US dollar index almost halved between February and December of 1987. The CPI, however, increased by a “mere” 4.4%.
The main reason why, historically, a weaker dollar may not have been particularly inflationary is that foreign exporters tended to absorb what amounts to a higher cost of doing business in a weak-dollar environment.
Because of competition, foreign exporters tend to be limited to two choices: reduce margins, as exporting to the US becomes less profitable, or stop selling into the US market if it is no longer profitable.
There are numerous ways to manage currency risk: they include hedging in the forward currency markets, but also include moving production to lower-cost countries or the country where the customer is located.
- Lower-cost countries tend to be the preferred destination for low-end consumer goods. Vietnam has seen a lot of investment as the cost of doing business in China has risen.
- However, for more value-added goods, producing closer to the consumer often makes sense. Toyota and BMW are two of the higher-profile examples that have built plants inside the US.
Active management of foreign-exchange rates can buffer many risks, leading to a mitigated impact on consumer prices. Having said that, the management of foreign-exchange risk can be an art as much as a science, and mistakes are made.
Chinese businesses love fixed exchange rates because it is one less item to worry about, but conducting business in a world with free-floating exchange rates is a skill learned over time—a key reason why Chinese policy makers are rather slow to allow the yuan to appreciate.
NEXT: Inflation’s on the Way|pagebreak|
Inflation’s on the Way
Bernanke may also be very wrong. That’s because he may underestimate just how far foreign exporters have been pushed in recent years, as the US may be pursuing an ever weaker dollar.
As US manufacturing has eroded over the years, foreign exporters may have another option at hand: passing the higher cost of exporting to the US onto US importers.
In an economist’s mind, that should not happen easily. We beg to differ and point to the spring of 2008 as evidence. At the time, import prices were soaring, reaching annual increases of more than 20% year over year; and it was not all driven by oil prices moving well above $100 a barrel.
Chinese exporters were starting to raise prices; and guess what—there was no US manufacturing to fill the void, so those higher prices had to be accepted.
In 2008, the US was “bailed out” by a financial crisis, causing pricing pressures to ease once again. With policy makers instigating a “growth at any cost” approach yet again, we may not be so lucky this time around.
The Financial Times writes, “Li & Fung (Hong Kong: 0494, OTC: LFUGY), a Hong Kong-based consumer goods sourcing and logistics company, warned that a new era in sourcing with higher prices has begun, as manufacturers pass on the rising costs of raw materials and Chinese labor to customers.”
Walmart (WMT) and Gap (GPS) in the US are among Li & Fung’s customers. While the firm has increasingly moved production to cheaper Asian countries, it continues to engage in acquisitions in China—making China more, rather than less, relevant in the sourcing business.
In fact, Wal-Mart CEO Bill Simon recently cautioned: "We're seeing cost increases starting to come through at a pretty rapid rate. Inflation is going to be serious."
US policy makers have to be careful about what they wish for. As the US dollar weakens further, foreign exporters may indeed be able to pass on higher prices.
Of course, American consumers may react by buying fewer of the gadgets they didn’t need in the first place. Now, policy makers are unlikely to be satisfied with such a reaction. Not only has Bernanke called for inflation to be higher, but he has argued that the economy needs to grow by at least at 2.5% a year, just to keep unemployment from rising.
Any consumer slowdown may be countered with more money printing or other monetary or fiscal initiatives. There is a real risk that we may be getting more than we are bargaining for.
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