Tuesday, June 24, 2008

How does inflation spiral out of control if neither wages nor prices will spiral?

Confusion marks the outlook
It's not only the Fed that seems confused about policy. I am surprised to find out how economists' views are still so split over inflation prospects. Many are still worried about inflation. Many aren't. Why?

Worried about inflation?

I'm not.

I was.

But I'm not.

What changed?

The economy, stupid.

It's tottering like a 98 pound beach weakling getting sand kicked in his face. And the big economist guys are afraid its going to beat them up. I don't get it.

This week's news
On Tuesday consumer expectations hit an all time low in the Conference Board report. The current conditions index was very weak. The component readings were so weak as to be distressing. The Richmond Fed MFG index fell sharply. Case-Shiller's house prices are still falling sharply.

Why worry about a weak Conference Board report?
The Conference Board employment readings are closely correlated with the rate of unemployment. So weak Conference Board readings and the spiking rate of unemployment are on the same page. Those are authentic signals... and signals of extreme weakness.

The corporate sector signal
UPS posted poor earnings because it COULD NOT pass through energy prices fully. Airlines are laying off pilots and cutting flights. These are not inflationary actions these are deflationary actions... and results.

What is different this time?
Look at the last oil cycle. Plot the CPI Vs its core... Do it for this cycle and for the one from 1973 - 1981 or so. What is different? Core inflation is lagging headline inflation badly this time. Last time they ran neck and neck. This is not read universally as a sign that the Fed is winning. Pessimists are waiting for the core to catch-up. Why? This is economics in action. Fed does not accommodate oil price increase as it did in the early 1970s so core inflation is held back. The rise in nominal oil prices becomes a rise in real oil prices. Consumer incomes are not kicked higher by accommodation (inflation) so the hike in oil does MAXIMUM DAMAGE to consumer spending as monies are diverted from discretionary spending to survival spending (oil). That slows the economy for sure but keeps inflation in check and allows the Fed to keep rates lower.

Look at markets: what are they saying?
Why did stocks hit a stone wall and drop last week after being encouraged the weak before by 'strong' retail sales? The reason is that it is becoming clear that there is no bounce in sales from rebates. Energy prices have simply risen too much and taken the punch out of the rebates. Store sales this week (Tuesday) rose by 2.2% Yr/Yr up from 2.1% the week before. These are not very good numbers. Consumer discretionary stocks fell hard last week- even consumer staples fell. These are not markets reacting like there are inflationary forces at work.

The un-thought, thought experiment
For those who are not convinced by the drum beat of incoming data - just consider how high oil/gasoline prices are. Pass-through is simply not occurring into the core rate. The weak dollar is not affecting (non oil) import prices by very much. With headline inflation pressured, what is getting through to the core is just a trickle. Firms are reluctant to hike prices. If oil moves much higher there will be a recession and that will stop any inflation COLD, right in its tracks. We may already have passed though that barrier in fact and we may be headed for recession now, even if oil prices do not rise that much more. So for those who believe in inflation, one question: how do we get there from here? It seems unlikely.

Lower core than headline inflation IS GOOD NEWS
The controversy is not that headline inflation is higher than core. That is a measure of Fed success. The Fed aims to keep that gap in place until such time that OIL PRICES FALL back to normal levels and that will squeeze or invert the headline to core price inflation gap. LOWER CORE THAN HEADLINE INFLATION is a SIGNAL of Fed success.

Not much risk of or from higher oil prices any time soon
At this point higher oil prices are not much of a threat to inflation, they are are a threat to growth. They are slowing consumer spending and eroding corporate earnings. These developments are not classical inflation signals. The gold market can tell that and that is why it has stalled. Airlines are laying off pilots. UPS, a very energy conscious, company was not able to pass on its rising costs with price increases so its earnings disappointed. Consumer discretionary stocks are not lagging badly because investors think rebates are going to drive the economy though its oil troubles. Go face to face with the new reality. The face of growth is grim... not the face of expected inflation.

Wag the dog?
So, tell me what in these stories is inflationary. What will become so? Why is inflation such a fear? And don't revert to saying India and China, please; they are far too small and will be themselves crippled by the coming slowdown evident in the US, Europe and Japan. The tail does not wag the dog.

Circular illogic
I sure don't get it. The fear is an irrational one. Higher energy prices will not beget higher energy prices and headline prices forever. At some point the illogic of this circle shows through. I think there is plenty of evidence that we have reached that point. Any higher, and energy prices will undermine themselves even more by undercutting economic growth and overall demand not just energy demand. Oil has done this before. It's in another bubble. I take this truth to be self evident. It's why I have no fear of inflation.

But neither wages nor prices are spiraling...BAD FORECASTS ARE
Inflation? You can't get there from here because the Fed is in the way and because of an ongoing market dynamic that exists on a global scale: firms are reluctant to hike prices - even for good reasons. Europeans were not demonstrating, clogging roads and ports because they COULD pass though energy price increases, now were they?
Wages are not part of a wage-price spiral. Prices are not part of a wage-price spiral. Its only oil and food. And they rob other prices of their ability to spiral. They do help to elevate headline inflation because of their importance and their gross inelasticity (e.g. you do not substitute away from food when prices rise; or walk to work because gas prices go up, etc). You do have less 'money' left over to spend on other things, hence deflation. So what is spinning out of control? I mean what besides BAD FORECASTS?

1 comment:


If prices spiral out of control and wages do not than we will see serious social unrest.