Inflation Inflation, what will you do?

Inflation is building up - or is it?
In my previous blog I almost admitted I had been a bit premature, forecasting looming deflation. However, thinking about it (and stirring the tea leaves at the bottom of the economic cup), the conclusion dawns that, although there are lots of question marks about the build up of inflationary pressure (mainly from the energy sector), in actual fact the equation is a lot more complex than one of "high oil prices mean higher inflation". Still, as this chart (courtesy of Contrary Investor) shows, the US experience is either pointing towards an upsurge in core inflation, pulled up by the headline number - or it's not:




Add in the strong move up in pipeline inflation (PPI) - crude and intermediate goods, and it is little wonder gold is reaching new highs. However, financial markets appear to be much more sanguine about the outlook for inflation - true, the bond market is getting nervous about inflation, but yields still look remarkably low.

The question is, therefore, whether inflation is building up a head of steam, requiring a stern policy response, or is in fact a one-off spike, which will tail off all on it's own, without the need for restrictive policies from the world's central banks.

And there's the rub, because it seems that the US Fed's easy money policy may have masked economic weakness for the last 5 years (helped by a few tax cuts, of course, but that weakness is getting ready to break cover, just as the Fed raises rates to stifle inflation. So inflation pressure may be building up, and there is probably no doubt that the labour force will try to recover spending power lost to inflation by demanding higher wages, but how successful will they be? At present US firms are reporting very strong profit margins, having spent the last few years trimming costs, and the Fed has indicated that it is watching earnings data to see if they will be used to absorb pressure from rising raw materials prices; unfortunately, recent Fed surveys have shown an increasing ability of some firms to pass on cost increases, which is bad news for interest rate doves. It seems highly unlikely CEOs will succumb to a bout of conscience, and start pushing up wages simply because of the squeeze on their workers' pockets. So, as usual some workers - those who still have some clout - may squeeze more from their employers, in general earnings are probably flat-to-down. Witness the good old UAW, which 4 months ago was laughing in Rick Wagoner's face as he pleaded for help to prevent GM sliding into bankruptcy, but which has now made a significant concession regarding healthcare benefits for hourly workers.

What does that have to do with cost-push inflation, as mentioned above? For some time many respected pundits have been questioning the ability of the US consumer to keep on spending - the maximum has been extracted from the house, credit cards are maxed-out, and the new bankruptcy law has just been introduced (although that will probably only affect the margins), and the question is whether companies can push through price increases as consumers slow their spending.

Obviously the basics, such as food, heating and housing, are much more price-inelastic, and thus the core figure has not tracked the headline data (yet). Plus the Fed has (in my opinion) been watching the fall in consumer good prices, and (with a calculator, pencil and a rubber...) offsetting the rise in one with the fall in the other, but as we cannot quantify this "tinkering", I am going to ignore it. But, with earnings growth soft and rising prices for essentials, what chance companies can make price rises stick? It seems unlikely, unless workers are able to force through wage rises, which seems unlikely unless US companies can get some form of protection from external competition. In short, the scenario leading to a sustained bout of inflation looks very unlikely.

Having said that, a lot of writers AND generic inflation indicators are saying inflation is looming; and if we see more big numbers in prices paid/prices received surveys, and big PPI and CPI figures, the Fed is almost bound to continue tightening past the current mooted target of 4.25/4.5%. If the inflation scare is a false alarm, what would rates above here do to the American consumer? And if the American consumer gives up, what happens to the rest of the world? I reckon we are back to the deflation scenario. Sometimes it pays to ignore the incidental detail and keep your eye on The Big Picture.

Joss Bolton

What is going on in the UK economy?

Various pronouncements recently purport to reveal signs of our economy's latent strength; you can forgive politicians, because it is their job to tell people what they want to hear - no politico ever got elected telling it as it is, except in a Hollywood film - but when the likes of Mervyn King start talking things up, you have to take notice.

Mervyn told a newspaper that the Bank is not targeting consumer spending, and therefore will not promise a rate cut in November, despite the decline in spending, and the supposed pain of the retail sector; so far, so good - we expected nothing else from the hawkish governor. However, he then went on to say that business investment and exports are taking up the slack, which is where I begin to question the data, and his pronouncement.

At the moment, we live in a very US-centred world; the American consumer is still doing his (her) best to drag the rest of the world along, and by providing exporting economies such as Germany and China with markets, these countries then drag along suppliers of commodities and other means of production by importing to manufacture their exports. If you believe, as I do, that when the American consumer finally begins to retrench, and starts saving for the hard times that lie ahead, the rest of the world will feel the impact dramatically, and economic slowdown is a given. Notwithstanding the potential for Japanese and European consumers to lower their savings rates and increase consumption, I think there will be enough of a lag between the fall in spending in the US and the increase elsewhere, that there will be a shock (unquantifiable, admittedly) which will lead to a sharp slowdown in many countries, the UK being one.

What chance is there that the internal economy is robust enough to overcome this event? This is what I think the politicians - and the Bank governor - are alluding to, and which is why Mervyn is so reluctant to lower rates: pumping up consumer spending by providing cheap credit is a quck-fix that postpones restructuring impulses, but doesn't remove the need for some pain at some point. I think that if Mervyn thought we were sliding towards a slump now he would cut, but a) until the US is clearly retrenching that is deemed unlikely; and b) if he uses up his ammo now, what will he do if the economy really does begin to slip?

Why then do I doubt his comments about business investment taking up the slack? Well, in the past few years it has been clear that the erosion of our manufacturing base is not being offset by a corresponding growth in new jobs that cannnot be easily and more cheaply replicated elsewhere - witness the growth in call centres, once heralded as the new service industry for mass job creation; already wage rates in this industry are beginning to fall. I do not see growth in any area sufficient to overcome the decline in older industries - and even services - that can be easily shipped abroad. In addition, the government share of spending is still increasing, and is unlikely to fall until after the next election (if then). As the major tax revenue streams decline with the loss of jobs, the burden will increase (directly or indirectly) on those still earning and spending. Unfortunately, much of this government spending (contrary to the chancellor's Golden Rule) cannot really be classified as "investment", and will not generate ongoing productivity improvements, and therefore is a drain on the economy. So Mervyn's comments about business investment do not ring true.

I confess to being a bit puritan where economics is concerned; I believe that things can not be rosy all the time, and every so often the bullet needs to be bitten, and necessary restructuring undertaken to allow new areas of the economy to supersede old, worn-out ones. This is painful, and lowering interest rates to ease this pain can be useful. Lowering interest rates to avoid having to undertake the restructuring altogether is probably a bad thing. This is something the ECB Chairman (and his predecessor) has been spelling out to poiticians for months. Is Mervyn perhaps "doing a Trichet", that is, telling politicians that while cheap money can help ease the pain of reform, it is no substitute for reforms themselves? Is he quietly letting us know that if corporate heads and politicians allow second-round inflation via acceding to excessive wage demands, rates will go up? I have a sneaky feeling that what Mervyn meant in his speech yesterday is that, despite weakness in some areas of the economy, there is a necessity for some robust reform, and he will not use interest rates as a palliative to avoid that reform; we just have to hope that he will use them if the reforms generate real economic pain.