Power, Coal & Inflation

Will the real inflation rate please stand up...?

DOES POWER come from being rich and prosperous? asks Dan Denning in his Daily Reckoning Australia.

Or do you get rich and prosperous by being hard working and frugal? Perhaps power comes from living beneath your means...?

We take up the question because in China – now the world's largest energy consumer according to the International Energy Agency – most of the power comes from coal (about 65%). The rest comes from a combination of renewables, geothermal, nuclear, gas, oil and hyrdo-electricity. When you're the world's largest consumer of energy, every little bit helps.

But how about a look in pictures to literally change your perspective? The chart below shows the world in terms of nuclear energy generated for domestic electricity consumption. On this map, which is based on 2005 figures, you can see that Australia is a virtual non-entity, dwarfed even by New Caledonia...the yellow blob of French origin to the right of the map.

The map, courtesy of www.worldmapper.org, shows what proportion of total global electricity production from nuclear occurs in each country...

You could argue that Australia is under-represented here, because its share of total electricity production from nuclear is very small in the global context. And in that, you would be at least partially right. Australia's share of total production is so small because it doesn't produce any electricity from nuclear and apparently has no plans too.

Aside from the public policy short-sightedness of this – especially if you believe that coal is killing the planet – what's the investment story? There are energy exporters in Australia who can profit from China's new energy pre-eminence. Among them are the coal companies (BHP, Rio, Centennial Coal, Whitehaven), the gas companies, the oil companies, the LNG companies, and the uranium companies.

If a single, over-priced, energy-efficient, short-lived florescent globe is never lit by electricity from nuclear power in Australia, we reckon you could still make money from the global growth of nuclear. That's the subject we've taken up in the July issue of Australian Wealth Gameplan. And it's why today's notes will be brief. We're going to try to meet a deadline for once.

But first, there's a puzzle to solve. Today's papers are full of stories on how the Reserve Bank of Australia will have to raise interest rates when it meets August 3rd, just 18 days before the Federal Election. The notes from the recent RBA meeting revealed two nuggets of interest.

First, the RBA expects inflation to rise. Putting aside the fact that it would know this already since it's responsible for inflation by keeping the real cost of capital below the market cost, the notes report that:

"Headline inflation was expected to rise, owing to the effects of some tax increases, with the year-ended increase in the CPI rising above 3 per cent. The important question for the Board at its next meeting would be whether the new information materially changed the medium-term outlook for inflation."

The "new information" is the reading on inflation for the June quarter. That data is due out next Wednesday. But here's a prediction: the RBA will not look at asset markets to find inflation. Of course, it need look no further than house and share prices, which have been propped up by various means. Without inflationary policies supporting asset markets, share and house prices would already be a lot lower.

But if the RBA instead looks at consumer prices, you never know what you're going to get. The calculations, with their seasonal adjustments, never seem to address the fact that most of us know intuitively: the cost of living is going up faster than wages. The RBA chooses not to report this because it shows that deliberately targeting 2-3% inflation a year as the bank does is another way of saying you're going to reduce purchasing power (sound and honest money) as a matter of policy.

If you put it that way, people would rightly punch you in the nose. But let us not forget what inflation is: theft. When you are allowed to purchase goods and services with newly created money that you get to use first, you are trading paper for real goods. The creators of paper money – central banks, commercial banks, and the government, get to use that money before it dilutes the purchasing power of all the other money in circulation.

It's a good deal if you can get it. But then, any time you can legally steal the productivity of others – getting the fruits of their labor at a discount – it's a good deal, even if it's deeply immoral and unethical.

The other interesting note from the notes is the extended discussion of the stress tests of European banks. The RBA is trying to sort out if more bank failures or higher capital requirements in Europe could threaten Australian banks that source a lot of their lending overseas.

To us, this is an implicit concession that the cost of capital in Australia is not really determined by the cash rate set by the RBA. It's determined by the global cost of capital. What does that mean? Tune in tomorrow for more discussion.

By the way, how do you know the real rate of inflation is understated? Check out the table below from the Treasury's updated budget review for 2011 earlier this month. Notice that Treasury is forecasting 9.25% nominal GDP growth in the next fiscal year. This generous forecast is part of what's expected to bring the budget back into surplus (along with high commodity prices and a historically high terms of trade).

But riddle us this: if the real GDP figure is just 3% and the nominal figure is 9.24%, doesn't that mean that inflation is running at closer to 6.25%...?

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Formerly editor of Strategic Investment with Lord William Rees-Mogg, Dan Denning is an independent investment analyst now based in Melbourne, from where he edits the Australian edition of The Daily Reckoning. He is also author of the best-selling The Bull Hunter (Wiley & Sons).

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