Headline Inflation Is The Only Place That's Tame

As expected, the headlines for both the consumer price index (CPI) and the producer price index (PPI) came in a bit higher than expectations but well below what many mainstream economists and Fed policymakers would consider troublesome.  Beyond the headlines is another matter.

The most important piece of information was buried on page 7 of the PPI press release.  The PPI measure of changes in margins received by wholesalers and retailers fell by 0.7% in January.  Price increases are now continually eroding the profit margins for the trade services.  Retailers, in particular, have been unable to transfer price hikes to consumers.  Electronic and appliance stores have seen the worst of this, along with gasoline stations and clothing shops.

Digging through the details of the PPI report one trend becomes clear – price increases are much more severe at the unfinished end of the supply chain.  As materials and goods move further along the production process, a lot of these cost increases are being absorbed at each step. 

For instance, in the crude materials segment we see a 1-year (January 2011 over January 2010) price index increase for wheat of 51%.  For corn, the increase was 63%; cattle for slaughter 27%; soybeans 36%; raw cotton 37%; crude petroleum 16%; wastepaper 39%; iron and steel scrap 36%; nonferrous metal ores 30%; aluminium scrap 20%.

If we move up the supply chain a step to “intermediate” materials and goods, the increases are less dramatic:  soft drink beverage bases 1%; prepared animal feeds 9%; finished fabrics 5%; paper 6%; wood pulp 21%; steel mill products 12%; primary nonferrous metals 16%; aluminium mill shapes 9%; motor vehicle parts 2%.

The release of the Philadelphia Fed Business Outlook survey showed just how much this margin squeeze is advancing.  The prices paid index surged to 67.2, up 13 points from January; and up 55 points since October.  It was also noteworthy that no firms reported decreasing prices paid; zero for the second consecutive month.  Unfortunately for manufacturers in the district, the prices received index only rose 4 points to 21.

The implications of the margin squeeze are straightforward.  If retailers and wholesalers begin to pass on price increases to consumers (what the Fed would call inflation) the entire trade system falls apart.  This is the entire reason for the collapse of margins at gasoline retailers since they remember well what $4/gallon gas did to their volumes in 2008.  Gasoline prices have shot up 13% since January 2010 but margins have fallen by 12.4% at gas stations.  Retailers are absorbing as much of the price increases as possible to preserve as much business as possible.

The margin squeeze is not limited to energy (outside of natural gas).  Going back to the fourth quarter GDP report we know that much of the “strength” in economic growth was due to a very large decline of imported goods (-13.6% from the third quarter of 2010).  That decline itself was the result of a 22% increase in aggregate import prices, of which energy products were only a smaller part. 

The big picture of inflation is really no better than the micro-scale rise in commodity prices.  I wrote in our February research report that:

“Real gross domestic purchases (total purchases by US residents wherever produced) fell by 0.3% in Q4 after growing 4.2% in Q3.  That is, total buying activity in the United States declined in the fourth quarter.  Actually total dollar volume of buying activity increased, real volume fell.  In other words, the United States paid more dollars on the whole to get less stuff.  I believe that is a fairly good description of inflation.”

What all these data points have in common is a pervasive inability of the US economy to absorb price increases.  In a more typical (if there is such a thing) inflationary environment wage and asset income rise in tandem with consumer prices, allowing for a drawn out boom period.  That is simply not happening in this environment because there is so much excess capital and labour capacity.

Because there is so much capacity the Fed believes that inflation, the general increase in consumer prices, is impossible.  With so much “slack” the Fed’s orthodox adherence to the output gap (the difference between economic potential and actual economic output) guarantees monetary “stimulation” for years to come.  Among other things, it means a continual tax on savers.

In the latter half of the 1970’s, wage income growth moderated but was replaced by interest income as the marginal source of spending.  It was enough to continue the inflationary system all the way into the 1980’s (asset income as a percentage of total GDP reached almost 14%).  Today, with the Fed fully committed to a zero interest rate policy there is no way for asset income to recover its marginal spending power.  That leaves earned income as the only option.

But, as we well know, there has been little improvement in the labour market and certainly not enough to counter the building inflationary pressures.  All of which means the economic trap is set.  Since this recovery is founded on big business profitability, the margin squeeze threatens that very foundation.  At the minimum, there is no way for businesses to begin large scale hiring now.  For small businesses that have yet to see profits recover, the noose simply tightens.

Where this all falls apart is the point at which price increases impact profit margins enough to force businesses to choose between continued profit deterioration and another round of cost cutting.  The latter option may not even be realistic at this point considering just how “lean” businesses have become in the past two years.  Both choices mean an end to the recovery in its current form.

There is a mistaken perception of exactly what stagflation is/was.  Stagflation is commonly thought of as a period of high unemployment coupled with high inflation.  But the reality of stagflation is a bit more complex.  It is/was a ratcheting cycle of boom and busts created by a mismatch of money/credit growth to real economic needs. 

Whether you believe the current price pressures are from too much monetary stimulus or strengthening global demand does not matter.  The end result will be the same.

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