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Reflections is a monthly publication

written by John Gilbert, CIO,
GRNEAM. Each issue focuses on
current capital markets and investment
topics. Our clients find it somewhat
unique from many investment
publications typically received.
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Unless otherwise attributed to a particular source,
the contents of and opinions contained in Reflections
represent only those of GRNEAM and should not be
attributed to GRNEAMs affiliates, its parent General Re
Corporation, Berkshire Hathaway Inc. or any of their
respective officers or directors.
Ination has been the conundrum of the last 30 years,
surprising many, including us. Ination should be
rising, but it is somnolent. This would seem to make
no sense. Ination erodes the purchasing power of
the currency and produces arbitrary redistributions of
wealth and income. If a county wishes to redistribute,
there are explicit ways of doing so in a democratic
process. But ination does it by stealth, and history
shows paper monies to be prone to debasement. Yet
there is no defensible theory of ination. Economists
have no explanation of ination that has stood the test
of time. The ink was barely dry on Milton Friedmans
Nobel Prize when his central assumption of stable
money velocity proved false.
Waiting for the Dog That Didnt Bark
June 2014
Issue 168
Reflections

GRNEAM 2
Lacking a reliable theory, the U.S. Federal Reserve has specied
a prevenient 2% target as their criterion of price stability,
essentially because it is a small number. We focus here on the
U.S. because of the dollars pervasive inuence upon nancial
markets, but the principles apply everywhere. A widespread
suspicion is that certain members of the Fed will look the other
way for a time if ination exceeds the target. And the history
of paper monies has proved them untrustworthy. That is why
recent ination data have received attention.
The most recent data show a rather sudden rise in U.S. ination
to the 2% target on the Consumer Price Index, although not
yet on the Personal Consumption Expenditures Deator, the
Feds preferred measure. The central banks view of this is that it
is early to worry, and it is true that previous such accelerations
soon reversed. The stakes have risen over time, however, as the
Fed has force fed the banking system with such a prodigious
volume of bank reserves in their QE programs.
Hence the notice given inations recent acceleration. The CPI
has rather quickly returned to the 2% target, led by food prices
(Chart 1).
Chart 1. U.S. Consumer Price Index
-3
-2
-1
0
1
2
3
4
5
6
2009 2010 2011 2012 2013 2014
CPI Food
Sources: Bureau of Labor Statistics and GRNEAM
In fact, the U.S. received a windfall in the form of food prices
over the last year or so. Food prices at the producer level
actually fell prior to the latest acceleration (Chart 2), which
relieved some of the upward pressure from other categories,
particularly proteins. The latter has been elevated by weather as
drought affected herds (Charts 3 and 4).
Chart 2. Producer Price Index, Food (Year / Year % Change)
PPI, Old Method PPI, New Method
-6
-4
-2
0
2
4
6
8
10
12
2009 2010 2011 2012 2013 2014
Sources: Bureau of Labor Statistics and GRNEAM
Chart 3. Grains
Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
300
400
500
600
700
800
900
$

p
e
r

b
u
s
h
e
l

*

1
0
0

Corn Wheat
Sources: Bloomberg L.P. and GRNEAM
Chart 4. Cattle
Live Cattle Feeder Cattle
Jun-13 Sep-13 Dec-13 Mar-14
140
138
136
134
132
130
128
126
124
122
120
200
195
190
185
180
175
170
165
160
155
150
Sources: Bloomberg L.P. and GRNEAM
Such short-term uctuations are highly volatile and may
be dismissed as noise and not signalup to a point. The
ination of the 1970s was characterized by very high levels
of commodity ination, and signs of such increases set off
alarms. Many of them are false. But it would be erroneous to
disregard commodity prices as unimportant. Commodity prices
have fallen in real terms because of the success of commodity
producing industries in eliminating the most costly factor of
productionlabor, and skilled labor in particular.
Real commodity prices are often measured using a broad series
such as the CPI. This has a recursive tendency, however, since
the CPI as a deator measures prices of goods that themselves
are made from commodities.
A better way to think about it is to use the price of skilled labor,
since that produces an image of how much room there is left
to squeeze out that costly factor of production, as Paul Gait
of Bernstein Research has shown. It is the reduction of labors
contribution that has allowed the value of commodities to
fall over time relative to other goods and services. In Chart 5
we show corn prices in the U.S. since the latter half of the 19
th

century, which captures the effects of the Second Industrial
Revolution and subsequent inventions. The First Industrial
Revolution began in the U.K. in the late 18
th
century, while the
U.S. was a more important participant in the Second.
3 Reflections, June 2014
Chart 5. Real Corn Prices, Skilled Labor Deator
$0
$50
$100
$150
$200
$250
$300
1
8
6
0

1
8
7
0

1
8
8
0

1
8
9
0

1
9
0
0

1
9
1
0

1
9
2
0

1
9
3
0

1
9
4
0

1
9
5
0

1
9
6
0

1
9
7
0

1
9
8
0

1
9
9
0

2
0
0
0

2
0
1
0

$

p
e
r

p
o
u
n
d
,

2
0
1
4

d
o
l
l
a
r
s

Sources: Global Financial Data, MeasuringWorth and GRNEAM
The pattern is not just corn, but applies to commodities of all
kinds. Charts 6 and 7 show the same result for copper and oil.
Chart 6. Real Copper Prices, Skilled Labor Deator
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
$40,000
$45,000
1
8
0
0

1
8
1
0

1
8
2
0

1
8
3
0

1
8
4
0

1
8
5
0

1
8
6
0

1
8
7
0

1
8
8
0

1
8
9
0

1
9
0
0

1
9
1
0

1
9
2
0

1
9
3
0

1
9
4
0

1
9
5
0

1
9
6
0

1
9
7
0

1
9
8
0

1
9
9
0

2
0
0
0

2
0
1
0

$

p
e
r

p
o
u
n
d
,

2
0
1
4

d
o
l
l
a
r
s

Sources: Bernstein Research, Global Financial Data, MeasuringWorth and GRNEAM
Chart 7. Real Oil Prices, Skilled Labor Deator
1
8
6
0

1
8
7
0

1
8
8
0

1
8
9
0

1
9
0
0

1
9
1
0

1
9
2
0

1
9
3
0

1
9
4
0

1
9
5
0

1
9
6
0

1
9
7
0

1
9
8
0

1
9
9
0

2
0
0
0

2
0
1
0

$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$

p
e
r

p
o
u
n
d
,

2
0
1
4

d
o
l
l
a
r
s

Sources: Global Financial Data, MeasuringWorth and GRNEAM
It is clear that the large majority of the scarce resource, skilled
labor, has been extracted from the production process.
Development of equipment that does not require an operator,
such as combines and mining trucks, may reduce costs
modestly, but the contribution is marginal. Factors other than
labor, such as weather in agriculture, and the secular decline
in ore grades in mining industrial metals, stand to rise in
importance if technological change such as those that have
occurred in oil and gas do not occur. In agriculture, seeds and
better farming practices have been important, but in mining
there has been little change in the technology of extraction to
offset the decline in ore grades.
We can safely say, however, that what is scarce is likely to
remain so. The scarcity is skilled labor. In fact since the Second
Industrial Revolution, skilled labor has left wages in general
behind as technological change rewarded those with the
knowledge and technical training to operate the equipment.
Chart 8 shows the trend in skilled versus unskilled labor over
the long-term, plotted on a semi log scale to cope with the rate
of increase.
Chart 8. Labor Costs (Indexed to Crossover, 1860 = 100)
10
100
1,000
10,000
100,000
1
7
7
4

1
7
9
4

1
8
1
4

1
8
3
4

1
8
5
4

1
8
7
4

1
8
9
4

1
9
1
4

1
9
3
4

1
9
5
4

1
9
7
4

1
9
9
4

2
0
1
4

I
n
d
e
x
,

1
8
6
0

=

1
0
0

Unskilled Labor Skilled Labor
Sources: MeasuringWorth and GRNEAM
Finally, Chart 9 is the relationship of skilled wages to the CPI.
It was only globalization of competition for American jobs that
proliferated in the 1980s that slowed the rate of wage ination
relative to general price ination.
Chart 9. Skilled Wages to CPI (1790 = 100)
0
500
1000
1500
2000
2500
3000
3500
1
7
9
0

1
8
1
0

1
8
3
0

1
8
5
0

1
8
7
0

1
8
9
0

1
9
1
0

1
9
3
0

1
9
5
0

1
9
7
0

1
9
9
0

2
0
1
0

Sources: Global Financial Data, MeasuringWorth and GRNEAM
This is why while attention is riveted upon the monthly payroll
count, the rate of increase in wages is at least as important
(Reections, May 2014). In chart 10 we show that when wage
ination has reached current levels in the past, the central bank
was already, or about to, raise interest rates.
Chart 10. Wage Growth and Fed Funds
0
2
4
6
8
10
12
0
1
2
3
4
5
1985 1990 1995 2000 2005 2010
F
e
d

F
u
n
d
s

T
a
r
g
e
t

Y
O
Y

C
h
a
n
g
e

i
n

W
a
g
e
s

Average Hourly Earnings, Private Nonsupervisory
Fed Funds Target Rate
Latest
Sources: Bureau of Labor Statistics, Federal Reserve, Bloomberg L.P. and GRNEAM
In its World Economic Outlook for the rst half of 2013 the
IMF concluded that the decline in ination over the last 30
years was due primarily to ination targeting by central banks.
Such a practice is interpreted as holding the central bank to a
particular, and low, rate of ination. So far this has not been
tested, but odds are high that at some point they will be.
The Fed will be hoping that the wage numbers are slow to
accelerate. If they are, then the Fed can proceed at their own
pace in addressing interest rates, which is likely to be a slow
one. But if wages do accelerate, the Fed will have to at least
address the issue in its communications and raise rates. The risk
is that they move too slowly and begin to lose the credibility
that they have enjoyed in recent years. This is yet another reason
that nancial markets vary from fully priced to overpriced for
the underlying level of risk.
ref1406-168
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