Ramblings of a Portfolio Manager

Is the Inflation Boogie Man Really Hiding in Ben Bernanke’s Beard?

Since the Fed embarked on its second round of quantitative easing back in mid-November, economists, portfolio managers and politicians alike have appeared on TV to argue whether the program is an effective stimulant to the US economy in the long-run and whether the end-result would be much higher levels of inflation in the short-term. Here we examine the inflation argument.
One faction of the inflation camp argues that loose monetary policy is a recipe for runaway price rises as it raises the demand for consumption and capital investment, often in projects that would be uneconomical under a normal monetary regime—the old “demand-pull” cause of inflation from the text books. An opposition group, the “don’t worry just yet” camp, however, have argued in favor of the classic Phillips Curve theory, that inflation is directly related to the level of employment in an economy and that there is a historical inverse relationship between the rate of unemployment and the rate of inflation. This “cost-push” textbook inflation, they believe, is unrelated to monetary policy and is far off given the persistently high levels of U3 (the official unemployment rate, hovering around 9%) and, especially, U6 (total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force—currently 16.1%) labor underutilization. Yet a third group, in the inflation camp, the “competition for resources” faction, has postulated that surging commodity prices (in part related to the weak dollar from QE2 but also directly tied to insatiable demand from fast-growing emerging markets) will export inflation to our shores regardless of easy money or tight labor. In this scenario, monetary policy is somewhat responsible for the level of prices as it drives up demand for commodities, thus raising the costs of raw materials to producers and food, energy and other necessities to consumers, but the rest of the world is the real culprit behind inflation, rates and money supply independent.
Whom should we believe in this heated and ongoing debate? To begin, there is some basis to support the inflationary camp’s position that loose money will ultimately result in inflation. The rise in the money supply, combined with no change in the output of goods and services, can create a situation where there is an elastic and excess supply of money chasing a relatively inelastic supply of “wants.” The result is, at the margin, the prices of those “wants” will increase, driving inflation. Where this theory falls short is that output, in the longer run, is fairly elastic as companies can increase capacity, explore for more natural resources, etc. Money alone doesn’t drive inflation, it is the consumers’ demand for that money and the things it can buy paired off against the producers’ ability to supply that demand. Currently, capacity utilization in the US is around 76%, about 10 percentage points below the normal rate of an economy at full output, and has slightly contracted in the last few months. Over the years, both the level of capacity utilization and the rate of change in capacity utilization have been good predictors of future inflation. Right now, neither indicator is pointing in the right direction, suggesting that even though demand for consumption and investment may be rising there is still sufficient slack in production capacity and the interest to increase it to keep inflation at bay for the time being.

As for the Phillips Curve crowd, there is evidence that employment levels can manipulate inflation in the short run. In the US services account for almost 80% of GDP, when Federal, state and local governments are included. As a result, labor costs are nearly 70% of total input prices to the economy. Any uptick in demand for labor, therefore, would seem likely to produce much higher costs to business and, thus, inflation. The Curve predicts an upward “death spiral” as lower unemployment produces a lower supply of workers and the higher wages they are able to demand further increases want of goods and services, thus causing companies to need to expand capacity and employment further. The dynamics of the Phillips Curve are complex and there has been much debate on its efficacy in predicting inflation over the long run, at which it has not done well. Many have argued that we need to get below a “natural rate of unemployment” (one that includes those perpetually in search of different employment or who just don’t want to work) before the demand for labor requires companies bid up the price to attract employees. Still others have argued that, over the long run, workers price their compensation to exactly match the rate of inflation, eliminating the upward “death spiral” the Curve prophesizes. The “stagflation” of the 70’s attests to the limitations of the Phillips Curve.

Finally, the commodity price theory has some basis but a number of drawbacks. As we mentioned, the stagflation of the 70s is an example where inflation was imported in the form of higher oil prices from OPEC while the economy sat with relatively high levels of unemployment. There is nothing to suggest that scenario cannot happen again, given the current turmoil in the Mideast, however, the 70’s OPEC embargo was an exogenous, manipulation of supply which turned out to be temporary. The world is a much different place in the current decade and though we have not reduced our addiction to imported oil, we have a much more flexible and diversified economy in which substitution can mitigate rising commodities prices (we’re already seeing such examples as aluminum replacing copper as those prices surge and abundant solar, nat gas and coal replacing more expensive oil). In addition, as we mentioned, services drive this economy, not manufacturing; raw materials comprise only about 5% of input costs. Inflation is an economic condition in which all prices rise, not just some. So we have a long way to go before the commodity alarmists’ dire predictions become of concern.

The ultimate question in predicting inflation is whether manufacturers will be able to pass the higher costs they incur (from whatever source) on to consumers. On Wednesday the Labor Department released the core producer price index, which excludes food and energy costs. It increased 0.5 percent in January, the biggest advance since October of 2008. Economists had expected a 0.2 percent gain. Most of the rise, however, reflected a jump in drug prices, which accounted for 40 percent of the increase and probably reflected a one-time price hike ahead of the implementation of Obamacare. The overall, non-core number, reinstating food and energy prices, rose a more hefty 0.8 percent, lending credence to the commodities inflation argument. This advance followed increases of 0.9 percent in December and 0.7 percent in November and marks the seventh straight rise in prices. These numbers represent costs to manufacturers. As we said, the ability to pass them on to consumers will ultimately determine whether we get inflation. On Thursday the BLS released the Consumer Price Index. The CPI increased 0.4 percent in January on a seasonally adjusted basis, half the level of the PPI. Moreover, increases in indexes for energy, commodities and for food accounted for over two thirds of the all items increase giving further support to the commodities faction--in fact, over the last 12 months, the food index has risen 2.1 percent and the energy index has increased 7.3 percent with the gasoline index up 13.4 percent—yet the annualized inflation rate for all items including food and energy, is rising at a rate of about 1.6%cent.

So how do we interpret the data above in light of the arguments from the various inflation/non-inflation camps? First we note that while prices have indeed risen to business, they have not shown to have risen as greatly to consumers, lending support to the fact that companies are currently unable to pass on price increases. There may be a time-lag effect operating here, however, the persistently high level of unemployment may also well be a contributor. With current capacity utilization levels historically low and unemployment high, we have a way to go before that ability to pass on prices emerges and inflation ignites. That does not bode well for corporate margins, by the way, but that’s a story for another Ramblings.

Secondly, there seems to indeed be a commodities price factor in the rise we are seeing in costs at the wholesale level but those commodity price rises don’t seem to be driving consumer inflation to the same degree. Part of this, again, may be the inability of manufacturers to pass on price increases--Q4 earnings reports from the likes of P&G, Kellogg, Clorox and General Mills suggest that may be the case right now-- but part is also reflective of a change the consumers’ model consumption basket used to calculate CPI—simply put, energy, food and other commodities are less of a component in the basket used to measure inflation than they were 20 years ago. In fact, housing is almost 40% of the CPI index weightings and the continued oversupply in that segment of the economy portends to hold down reported inflation for a long time to come.

Finally, as we have seen throughout the recession and recovery, manufacturing productivity has risen dramatically—something no camp can seem to fit into their models. This means that companies are now, and most likely will be into the future, able to produce the same amount of output with fewer workers and fewer raw materials. This argues against any short-term Phillips Curve bump in inflation—unless 9% becomes the new natural rate of inflation, which we doubt (and pray for to be otherwise)—and suggests that companies will continue to be more efficient in their raw material per unit consumption. Continuing productivity enhancements are the one glitch in all the above camps’ inflation models.

In summary, in our opinion, all three theories of inflation are at work here and for the moment, are counterbalancing one another, keeping inflation low. We may yet see the inflation the easy money and commodity camps suggest, but the Phillips Curve folks, combined with a fair amount of slack in manufacturing and productivity enhancements, are keeping it in check for now and into the foreseeable future. Interestingly, from the recent Fed minutes, that also appears to be what the Federal Reserve is seeing…so for now we’ll take a page out of Investing 101 and not fight the Fed.