There are two types of consumer price inflation. There is wage-push inflation…and cost-pull inflation. Or, is it the other way around? Doesn’t matter. The most familiar type of inflation comes when an economy heats up…companies need more labor…so workers demand more money.

Employers meet the new wage demands…and then raise prices to maintain profit margins. Result: consumer price inflation.

The less familiar type of inflation happens when retail prices are pulled up by higher input costs. This is a very different kind of inflation because it provides consumers with no way to pay the higher prices. So far, we’ve seen very little increase in wages. As prices go up, consumers must cut back. This has the obvious effect of reducing demand…and reducing price pressure. Just as wholesale prices work their way down to consumer prices, so does consumer resistance work its way back up to producers. Effect? De horses go down and den dey come back. Doo dah. Doo dah. Producers cut back on production in the face of lower demand. Result: prices fall.

But here we introduce three wrinkles each one the size of the Rocky Mountains.

First, have you heard that word… “decoupling?” We were afraid to use it; we thought it described the end of a porno movie. But now we discover that it really refers to the parting of the ways…between the mature economies of the US and Europe…and the growing economies of the rest of the world. It was presumed for a very long time that “if the US sneezes, the rest of the world catches a cold.” Well, now we’re not so sure. The rest of the world seems to have developed an immunity to America’s germs. We don’t know; but maybe a consumer slowdown in America would not keep the Chinese, Indians and Russians from buying. Result: the normal corrective feedback loop would be twisted and broken. Prices would still go up, even though the US economy was in a slump. This would put Americans in a terrible position where they were earning less money but their costs of living were still going up.

Second, global prices are denominated in dollars. And the custodians of dollars the feds are determined to keep Americans spending money, even if they don’t have any. ‘Rebate’ checks… mortgage bailouts…lower rates…lower lending standards the feds are going all-out, trying to keep the money flowing. Our guess a year ago was that this flood of liquidity would buoy up oil, gold and commodities. It certainly has done that. But will it continue?

This brings us to our third crease. Many commodities seem to us to be near bubble territory. Oil, for example, is an important commodity. But it’s just a commodity. It has users. It has producers. Barring a war, the relationship between supply and demand doesn’t change overnight. How is it possible, then, that the price should double in less than two years…or that it could go up another $25 before the end of the year (as much as the entire oil price 5 years ago), as T. Boone Pickens predicts? How could it go to $200, as Goldman predicts?

The answer is simple the price is rising on speculation, not supply and demand. Oil may already be in a bubble.

Five years ago, there was only $13 billion invested in oil market indices. Now, there’s $260 billion, according to an article in the FT. In the futures market, oil is usually sold short as oil companies hedge future production. In 1990, only 13% of open interest was long. Today, 58% is long.

Besides, markets work. When prices go up it draws forth new supply. In yesterday’s news, for example, we found that oil companies are spending 4 times as much on exploration and drilling as they did 8 years ago.

Of course, there are reasons to think oil may go higher a lot higher. But markets are markets…and bubbles are bubbles. And there’s one thing you can count on bubbles always pop.

Source: The Bond Market Speaks! Inflation Still Rampant!

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