Tuesday, May 03, 2011

John Cochrane On Inflation, Treasuries & US Spending

John Cochrane of the University of Chicago's Booth School wrote an editorial in Thursday's Wall Street Journal explaining why the US federal budget for 2025, seemingly so far off in the future, matters today.

Cochrane periodically pens editorials in the Journal, and they are always well-written and -reasoned. This one was no exception.

Early on, he associated current returns on a 30-year Treasury of 4.5% with a real 2% return, implying a long term inflation rate lower than 2.5%. With that rather risky bet as a background, he noted that such a belief of low inflation means,

"you have to bet they will solve the 2025 deficit. If you decide that the government will just keep kicking the deficit can down the road, sell your 30-year Treasuries. Sell fast, before everyone else does- because if we all try to sell, we just drive down the price and long-term interest rates rise."

Cochrane went on to chide the government for making the same mistake that Bear Stearns and Lehman did in 2008, i.e., fund excessively short-term for alleged reasons of lower cost, ignoring the risks of funding drying up when refinancing is undertaken. He warns,

"It is cheap precisely because it is dangerous."

So true, because the lender's view of short-term finance is that you aren't liable for the longer-term default. You only have to bet that the borrower, in this case the US, will manage to remain solvent for another few quarters or a year.

I won't go into Cochrane's comments on budget cuts, tax rates, etc., because they are more political in nature, and this is my business blog. However, he closes with these passages,

"The challenge is whether we will accept a vaguely rational tax system and a set of entitlements that protect the vulnerable without bankrupting the Treasury. It's not rocket science.

But we don't have much time. The bond market won't wait. The budget and debt problems will be much harder to solve if long-term interest rates spike, the dollar falls further, and inflation breaks out."

That last line caught my attention after I reread the piece following my reading of the weekend Journal's lead interview with Smithfield Foods CEO C. Larry Pope. Here are some of the passages from that piece,

"Mr. Pope is the chief executive officer of Smithfield Foods Inc., the world's largest pork processor and hog producer by volume. He doesn't mince words when it comes to rapidly rising food prices. The 56-year-old accountant by training has been in the business for more than three decades, and he warns that the higher costs may be here to stay.

It's also a business under enormous strain. Some "60 to 70% of the cost of raising a hog is tied up in the grains," Mr. Pope explains. "The major ingredient is corn, and the secondary ingredient is soybean meal." Over the last several years, "the cost of corn has gone from a base of $2.40 a bushel to today at $7.40 a bushel, nearly triple what it was just a few years ago." Which means every product that uses corn has risen, too—including everything from "cereal to soft drinks" and more.

Inflation: An overview of the prices consumers really pay .What triggered the upswing? In part: ethanol. President George W. Bush "came forward with—what do you call?—the edict that we were going to mandate 36 billion gallons of alternative fuels" by 2022, of which corn-based ethanol is "a substantial part." Companies that blend ethanol into fuel get a $5 billion annual tax credit, and there's a tariff to keep foreign producers out of the U.S. market. Now 40% of the corn crop is "directed to ethanol, which equals the amount that's going into livestock food," Mr. Pope calculates.

The rapidly depreciating dollar is also sparking inflation, although Mr. Pope says that's a "hard" topic for him to discuss, trying to be diplomatic. But he doesn't deny that money is cheap. Investment bankers are throwing cash at the firm—a turnaround from 2008, when money was scarce—even though Mr. Pope doesn't need it right now.

Now food price inflation is popping up across the country. A pound of sliced bacon costs $4.54 today versus $3.59 two years ago and $3.16 a decade ago, according to the Bureau of Labor Statistics. Ground beef is $2.72, up from $2.27 in 2009 and $1.74 in 2001. And it's not just Smithfield's products: "You eat eggs, you drink milk, you get a loaf of bread, and you get a pound of meat," he drawls. "Those are the four staples of what Americans eat in their diet. All of those are based on grains."
"Maybe to someone in the upper incomes it doesn't matter what the price of a pound of bacon is, or what the price of a ham, or the price of a pound of pork chops is," he says. "But for many of the customers we sell to, it really does matter." Workers can share cars when the price of oil rises, he quips, but "you can't share your food."

Mr. Pope also worries about the impact on farmers, who are leveraging up operations to afford the ever-rising price of land and fertilizer that has resulted from the increased corn demand. "There are record prices for livestock but farmers are exiting the business!" he exclaims. "Why? Farmers know they won't make money."

Weather is a factor, too. "We've had the luxury for the last three years of extremely good corn crops, with high yields and good growing conditions. We are just one bad weather event away from potentially $10 corn, which once again is another 50% increase in the input cost to our live production."

Food price inflation isn't a problem confined to America's shores. "This ethanol policy has impacted the world price of corn," Mr. Pope says. The Mexican, Canadian and European industries have "shrunk dramatically. . . . We have an unsustainable meat protein production industry," he says. "We're built on a platform of costs, on a policy that doesn't make any sense!"

Nor does the science. The ethanol industry would supply only 4% of the nation's annual energy needs even if it used 100% of the corn crop. The Environmental Protection Agency has found ethanol production has a neutral to negative impact on the environment. "The subsidy has been out there since the 1970s," Mr. Pope says. "If they can't make themselves into a viable economic model in 40 years, haven't we demonstrated that this is an industry that shouldn't exist?"

So what's the solution? First, Mr. Pope says, get rid of the ethanol subsidies and the tariff. "I am in competition with the government and the oil industry," he says. "It's not fair." Smithfield's economists estimate corn prices would fall by a dollar a bushel if ethanol blending wasn't subsidized. "Even the announcement that it is going away would see the price of corn go down, which would translate very quickly into reduced meat prices in the meat case," he says. Imagine what would happen if the mandate and tariff were eliminated, too.

He also advocates lifting regulatory and tax burdens on business. "I fundamentally don't understand the logic of corporate income taxes," he tells me. "If I have a 35% tax, all I do is take that 35% tax and I transfer it into the price of bacon and the price of pork chops."

Mr. Pope says the "losers" here "are the consumer, who's going to have to pay more for the product, and the livestock farmer who's going to have to buy high-priced grain that he can't afford because he's stretching his own lines of credit. The hog farmer . . . is in jeopardy of simply going out of business 'cause he doesn't have the cash liquidity to even pay for the corn to pay for the input to raise the hog. It's a dynamic that we can't sustain."

Coming on the heels of Bernanke's much-lauded first Fed press conference, Pope's remarks and Cochrane's editorial are quite sobering. Pope is quite explicit in painting the US ethanol policy as damaging to food prices with virtually no impact on oil importation, while ruinously effecting the price of corn as a global food supply mainstay. Then there's weather, which so few of us pay attention to for farming. Pope offers a rather cold-eyed assessment that we're almost certain to experience weather that could more than double current corn prices!

 I wrote about that Bernanke's remarks,

"Yes, Bernanke did attempt to claim that commodity prices have surged due to developing nation demand, as Cramer predicted. Not that it was such a hard call to make.

The trouble is, it's not just oil. I don't think US food demand is down as much as its oil consumption is from a few years ago. But we have broad grocery store inflation approximating 10%.

Bernanke's hopes for moderated inflation while Americans pay more for food and gasoline just aren't believable. Further, technically, inflation is a monetary phenomenon, and Helicopter Ben has been monetizing Treasury debt and presiding over a weakening dollar."

So there you have it. A rather candid triangle of Bernanke spinning the Fed's ultra-cheap dollar policy as having absolutely nothing to do with imported inflation, Cochrane warning that even a whiff of inflation makes today's 30-year Treasury yields razor thin, and Larry Pope, a pragmatic pork processor CEO forseeing years of high food price inflation.

Who do you believe? The government employee, the financial academic and/or the CEO? No more than two can be right. If either Cochrane or Pope are right, Bernanke can't be.

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