The two charts below offer a way to evaluate the risk of profit margin squeeze in the current economy. One is the ratio of crude to finished goods in the Producer Price Index (data through February). The other is an indicator constructed from two data series in the Philadelphia Fed’s Business Outlook Survey. It is the spread between the Philly Fed’s prices paid (input costs) and received (prices charged) data.
A major risk factor for margin squeeze is the increase in commodity prices over the past several months. The latest turmoil in the North Africa and the Middle East has now putt oil prices in the spotlight.
So let’s take a broader view of these two indicators by viewing them within the context of inflation as measured by the Consumer Price Index. As the first chart clearly shows, the all-time high in the PPI crude:finished-goods ratio was in July 2008, the same month that crude oil and gasoline prices in the US hit their all-time highs. The previous ratio high was in the summer of 1973, a few months before the outbreak of the October Arab-Israeli War and the Oil Embargo. Inflation had already been rising in a series of waves since the mid-1960s. But Middle-East events of 1973 were the primary trigger for the nearly 10 years of stagflation that followed.
The Philly Fed Prices Paid Minus Prices Received Index is an extremely volatile series, which I’ve emphasised by using dots for the monthly data points. To highlight the underlying pattern, I’ve included a 12-month moving average (MA). The two date callouts, one for the February monthly data point and the other for the 12-month MA, show that the comparable levels in the past were associated with inflationary peaks. The March ratio is down from last month but still extremely high: It is at the 98th percentile of the 515 monthly data points in this series. The 12-month MA for the ratio is at an all-time high.
By official government metrics, the CPI and PCE, inflation is not a near-term threat. In fact, the Federal Reserve has been working hard to raise the level of core inflation.
Of course, there are many differences between the inflationary decade of the 1970s and the present, not least of which is the rate of unemployment. In August 1973 (first chart above), unemployment was at 4.8%. The latest Gallup Poll unemployment survey puts the mid-March rate at 10.2%, over a percentage point higher than the 8.9% February number from the Bureau of labour Statistics. Also, US demographics are quite different. The oldest Boomers were turning 27 in 1973. They were at the beginning of their careers with decades of wage increases in their expectations. This year they are turning 65, and many are already on Social Security as their main source of income.
At present, in light of the unemployment rate and the ongoing demographic shift, the rise in commodity prices probably poses more risk of margin squeeze than run-away inflation. Some degree of cost-push inflation may be a near-term risk, but the demand-pull inflation we saw in the 1970s is difficult to evision in the US economy of this decade.
The next Business Outlook Survey will be released on April 21, 2011.