Inflationconcerns,commodityriseandBenBernanke

Dow Jones touched the peak of 35k for the first-time during yesterday’s trading. However, it ended the day in slight red. The other equity markets were not so lucky as tech heavy Nasdaq fell 2.55%. In the morning trade today, both Hang Seng and Nikkei are down by more than 2%. The chatter on the street is that the market is getting nervous about inflation and how it will impact the interest rate trajectory and bond purchases. The US CPI data is set to be out tomorrow. The surge in commodity prices across has also led to a belief that all this will feed into the input costs of the companies and they will need to raise prices to protect the margins. The rising prices will then kick an inflationary spiral. Commodities like iron ore, copper, palladium, silver have all touched multi-year high levels in last few days. The prices of the agri commodities are also surging. In such a scenario a seasoned wordsmith will be required at Fed to prove that high inflation is just a transitory phenomenon. In India also we will have the CPI data coming out on 12^th May.

Whenever there is lot of discussion about inflation and hyper-inflation and how it will affect the various asset classes, it is good time to take a step back and think in terms of first order principles. The price is rising but in what terms and which denomination? It is denominated in a fiat currency. Fiat currency as the name suggests derives its strength by fiat i.e. order by an authority. One can imagine the central bank backed by their respective governments as the authority here. The currency then serves three purposes i.e. medium of exchange, store of value and third is a unit of account. For anything to qualify as money it should satisfy these three attributes. A commodity (industrial or agricultural) lacks on the medium of exchange part but scores well on store of value. Also, it can be directly consumed (industrial or personal use). Fiat money on the other hand can’t be consumed directly. It has to be converted into some consumable form to derive its value (bread, cheese or iphone).

We see that any form of money is only as good as the degree of confidence it inspires. History is replete with examples where decentralized systems emerged spontaneously and some token gained eminence as money. It need not be always a Dollar or Euro bill, as it can be anything which people believe has a value and can be traded to purchase something else. Ben Bernanke the former Fed Chief and the intellectual fountain head for the easy liquidity policy gives an example of one such decentralised money in his book Principles of Economics. He cites the example of cigarettes circulating as currency in many prisoners of war camps during WW II. Cigarettes could be stored, easily exchanged and hence had a natural winner edge over other things like cheese or bread (which can’t be stored). The supply was also limited as it was restricted by the jail authorities.

In case the jail authorities decided to install a cigarette manufacturing facility in the jail compound, the value of the what you can purchase with one bud will reduce sharply. Readers by now can sense the drift of the argument, the exercise was to get some perspective on the commodity price rise or for that matter the mania for digital currencies. But one word of caution here, the economic world doesn’t exist in a vacuum. It resides in the wider social world where there are multiple actors who wield different levers of power. Economics, markets, currencies are just one part and not the whole world. So, any one-way prediction on the fate of fiat currency is nothing but oversimplification.