Bottleneck Theory of Inflation

Andy Xie has an interesting theory about inflation.

Specifically, Xie argues that bottlenecks can form in certain asset classes – such as oil – even in a weak economy, which can lead to inflation:

Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don’t think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates

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