The Coming Increase In Inflation

The Coming Increase In Inflation
Photo by David Thielen / Unsplash

Inflation is about to increase due to several factors:

  • Oil prices re about to go to over $100 per barrel again
  • Wages are still increasing
  • Other raw material prices are no longer going down.

The good news? Used car prices are still declining!

Let's start with oil. The supply demand situation is changing dramatically right now . The biggest impact is coming from China as it reopens from the zero COVID policy. The most conservative estimate is that their daily oil demand will increase by 1.5 million barrels a day but professional oil traders tell me that the demand could increase by up to four million barrels a day.

This amount of increase in demand is enough to take the price of oil to over $100 per barrel.

At the same time that Chinese demand is increasing dramatically we are seeing a shrinking in the supply of oil. Russia has just announced that they are cutting production by 500,000 barrels a day. This is about 1/2 percent of total supply per day.

On top of this we see that OPEC is cutting supply by at least 1,000,000 barrels a day .

The price of gasoline declined last year as the US released about half of the Strategic Petroleum Reserve into the market. The Strategic Petroleum Reserve is now at a 39 year low so it is unlikely that any oil will be released this year. But even a release in oil will be a minor amount of oil not at the scale we saw last year.

The only thing holding down the price of oil will be a recession in the major western economies such as the United States. A decline in western economies would offset all of this bullish change in the supply demand balance. So the key to future oil prices will be whether or not there is a recession in the West.

But notice that a recession in the West would probably only just offset the newly bullish supply and demand considerations.

This suggests to me that the worst case scenario is that oil stays near current levels and the best case scenario is that we go back to $120 per barrel .

The price of oil affects the price of everything because energy is a part of everything. Even service industries are affected by the price of oil. So the price of oil will probably be a big part of an increase in inflation.

Real wages are declining because inflation is higher than increases in wages. Wages are a lagging indicator in the economy. So that suggests that wages will continue to increase no matter what inflation does but will increase more if inflation continues high or increases. Right now, due to a shortage of workers, we see strong nominal wage growth which feeds directly into inflation. Like oil, wages affect everything.

Wages are accelerating right now and will be providing strong upside pressure on CPI.

At the same time this is going on, we are no longer seeing a decline in other raw materials. The CRB index, which measures raw material prices , has been stable for about four months. The decline in raw material prices was a major reason why headline CPI declined. But that downside pressure is no longer there. As a result , CPI , which measures changes in prices from a year ago and a month ago we'll no longer have a positive comparison.

The bottom line is that the Fed is going to see inflation stay higher than it and the market believe at this point. That means that the Fed will have to increase interest rates higher and longer than the market believes at this point.

So this leads to a scenario where there must be a significant countertrend move against the trend that has been in place since last October. The timing of this significant countertrend move is a little hazy to me but I suspect that it will be in the second quarter of this year as more negative data come through.

So that would suggest a decline in the stock market of perhaps 5 to 10%, and the same thing in the price of gold. We would also see long term interest rates move higher and the dollar move higher.

As I write this, we are seeing a micro countertrend move which could be the beginning of this major countertrend move. But I don't think so. I think we're in the middle of a normal countertrend move not a big significant one.

The big countertrend move I'm looking for would be , quite frankly, a normal correction in a bull market not the beginning of a new bear market

So how do we make money from all this?

I think we have to stick to our long term bullish positions in the stock market for now. The current mini countertrend will end in a week or two. So staying long makes most sense for most investors.

Down the road, perhaps in the second quarter, we will have to be more aggressive on the short side in these markets.