PIMCO Bracing For Higher Commodity Prices & More Inflation

Even though the US Federal Reserve downplays the contribution of commodity prices in the US core inflation rate, that doesn’t mean that everyone agrees. In fact, most of us who pay more for a gallon of gasoline or a head of lettuce see higher prices for necessities like food and fuel eroding our purchasing power. And because we don’t want to run up expensive credit card debt, we tend to keep our wallets firmly in our pockets or purses.

Now, investment management giant Pacific Investment Management Company LLC, or PIMCO (or even Pimco) as it is commonly known, has released its outlook on commodity prices and inflation, and the firm sees things more like ordinary folks than does the Fed.

Greater demand for commodities, particularly in emerging markets which are growing much more rapidly than developed countries, is driving up the price of commodities for everyone. The US and Europe are feeling the pinch, but so are the emerging markets that are driving the price hikes. In fact, emerging markets are feeling it more. Indian consumers spend about 60% of their income on a typical consumption basket, while US consumers spend about 25% of theirs.

Pimco expects developed market inflation attributable to higher commodities price to rise to an average of about 3% and emerging market inflation to rise about 5% over the long-term.

The firm also warns that attempts by developed markets to devalue their currencies will lead to a rise in inflation among countries like the US that are net importers of goods. Emerging countries trying to fight off the effects of of inflation as their currencies appreciate may, in turn, export inflation to the developed markets that buy from the emerging economies.

Pimco’s conclusion is that “the goldilocks days of the ’90s where nations could have strong growth and low inflation simultaneously are gone.” As a hedge against rising inflation, Pimco recommends that investors allocate some investment to commodities. The two it suggests are crude oil and copper.

No real surprise there. Both are critical to future growth and both face supply constraints. If demand growth in emerging markets, particularly China and India, supplies could come under even more pressure. It takes a long time to develop new supplies of either, and both are becoming increasingly difficult to find in big, rich deposits.

Pimco also recommends that investors consider inflation-protected bonds, which are out of favor because the returns are so low. But if, as Pimco expects, those rates stay low, the Fed could raise its 2% inflation target or the low-interest rate policy could just be allowed to continue for a long time, allowing inflation to rise slowly and eat away at US government debt.

Some economists have suggested raising the Fed’s inflation target to as much as 4%, arguing that with interest rates so low the US should borrow more, but spend it more wisely. And by that they mean directing the borrowing to employing more people.

Bill Gross, Pimco’s managing director, noted in his latest Investment Outlook that “U.S. employment based on asset price appreciation/finance as opposed to manufacturing can no longer be sustained.” As long as Fed policy and legislative action do little to improve employment prospects, the US economy will do no more than continue to sputter along. Rising commodity prices and inflation will only make things worse.

Paul Ausick