19 May 2006 Will Inflation Spoil the Party?
Last week we discussed the abundance of global economic growth and how, so far, it had not been accompanied by excessive inflation. Even in the face of commodity prices rising straight up, record oil prices, rising wages, and tight supplies in almost all raw material category. The pressure relief valve is productivity. It has been rising steadily all over the world, keeping a lid on inflation.
But the question on investors’ minds for the last few days is how long will the “Goldilocks” expansion run before Central Banks, fearing inflation, begin reigning in on its growth with higher interest rates? The numbers released this week on inflation were a bit mixed, but probably did more to increase worries rather than dispel them.
The PPI, which represents prices at the producer level holding out the more volatile food and energy components rose only .1% last month; better than expected. It shows that businesses are absorbing the higher costs to make their products rather than passing them along to their customers. It is not overstated to say that most fear that price increases will create openings for their foreign competitors to steal market share with lower prices. But everyone wonders just how long they can continue to avoid the inevitable price increases. The answer is as stated before, as long as productivity remains high.
To continue improving their productivity companies are investing heavily in capital equipment. Industrial production of capital goods in theUSis up 12.5% year over year and at a record high in April. European majors are also spending heavily to improve their productivity. Germanyis up 6.7% for the past two months, near a record high in March. Franceis up 6.7%, at a record high in March, andItalyis up 8.9% in March.
On the other hand, capital goods output is up only 3.8% in theUKthrough March. Surprisingly, it is down 1.9% inJapanthrough March. Commodity-rich countries are using their windfalls to order more equipment and machinery to drill, mine, extract, store, process, transport, and ship their commodities. Soaring profits for manufacturers of these goods and tightening capacity utilization rates are stimulating capital spending in the industrial economies. All this additional capital spending is boosting productivity.
So far it does not appear that inflation will come from the production side of the economy, nor will they come from imports and a cheaper dollar. According to economist Ed Yardeni, global competition should offset much of the inflationary pressures resulting from a weaker dollar. Currently, there’s no inflation in core import prices, and plenty of deflation. The year over year increase in core import prices dropped to 0.8% in April, the smallest gain since October 2003. Deflation in capital goods import prices has pushed the year over year percent change in the PPI for capital goods down toward 1%. Cheap imports are also helping to restrain consumer goods inflation.
Rising wages could be the bullet that gets through the armor. The core CPI rose to 2.3% year over year in April, after hovering around 2% for about a year. Tightening production capacity, particularly wages could cause an upward creep in core inflation which, according to Yardeni, could force tenant and owner-occupied rents up. These trends would keep the Fed on a tightening binge. Yardeni explains that higher wages tend to boost rents which can push interest rates up causing more people rent rather than to buy houses. The good news is that the Fed tends to prefer the core PCED, which has a much lower weight for rent and other major indices than does the core CPI.
So what are some of the other components of CPI, and what can the Fed do to stem their increasing prices? Medical care services account for 6.2% of the core CPI and were up 4.1% year over year. In April, CPI prescription drug prices rose 0.3%, or 5.2% annually. The $64,000 question is how to stem the rising tide of medical care. Rising interest rates will almost certainly do no good.
In April, CPI education was up 0.5%, or 6.1% y/y. College applications are soaring and many are accepting no one on their waiting lists. America’s kids want to learn so they compete in the global economy. Should the Fed raise interest rates to cap tuition costs?
CPI airfares rose 4.6% annually in April. The Fed could lower jet fuel costs and airfares by causing a recession and reducing demand for travel, but that seems a steep price to pay to bring down the core inflation rate.
Do we have a serious problem with core inflation? Simply relying on history as our guide fails to address the dramatic deflationary forces at work in a very competitive and rapidly developing global economy. Recent trends in the core CPI are not good, but they have been expected as a likely outcome of sustained high energy and commodity prices. Whether they will reach levels sufficient to cause real inflation will be proven by future releases from the government. The markets are uneasy because investors are not sure if the Fed will overshoot. The experience level with Mr. Bernanke, the Fed’s new Chairman is very limited.
Mr. Bernanke and the Fed will gain some significant pieces of the puzzle in the coming weeks before their next meeting on June 29th, including their closely watched GDP Personal Consumption Core Price Index released next Thursday. The bond and stock market most recently suggest the group-think is for an overshoot in rates, causing a recession. But remember the euphoria of just two weeks ago when the stock market, according to the Wall Street Journal, celebrated “the slower-than-expected growth in April payrolls, embracing it as a sign of a not-too-hot, not-too-cold Goldilocks economy and that the Fed could thus soon suspend the upward push on rates.” The Dow Jones Industrial Average closed out the week at a six-year high and about 150 points short of its all-time closing high.
We don’t know what Mr. Bernanke is going to do, but we are pretty sure the global economy is considerably stronger than ever before, and getting stronger. As it grows, more customers for American goods are created. And the best sign of the health of business is its earnings. Forward earnings for the S&P 500 suggest an increase of 17% by December 2007. Investment in capital goods by these companies also suggests their confidence in continued growth. Markets and economists may be more uncertain about the future than usual, but business managers seem as confident as ever as they invest billions in the growth of their companies. Eventually, stock prices are based on earnings growth and those who create those earnings are banking on growth.