Global Trend

Inflation Remains a Non-Issue

Many Americans assume that inflation is rising. They fear that the recent increase in commodity prices will lead to higher finished goods producer prices and then higher consumer prices. This fear is intensified because people tend to notice when prices go up for products they buy most often.

As economist A. Gary Shilling points out in a recent commentary, such “widespread fears of inflation are understandable. Historically, inflation is a wartime phenomenon when government spending is huge, while deflation reigns in peacetime. Still, the nation suffered a uniquely long 60 years of war, which started with rearmament in the late 1930s, was followed by World War II, which promptly gave way to the Cold War that was augmented by the War on Poverty. So, most Americans have never experienced anything but inflation, which they believe is the way God made the world.”

However, such selective application of recent history to the future inevitably leads to bad decision making. This is particularly dangerous when the real threat to our economic health would be letting the undercurrent of benign deflation turn into a riptide of malignant deflation like that which crippled Japan in the ‘90s.

Let’s start with the most obvious potential source of inflation: soaring commodity prices, especially for oil. The worriers who expect commodity prices to ripple though the economy, with earthquake-like ramifications, are missing an important point. There is a tremendous amount of value added between raw materials and finished goods ? by labor, transportation, packaging, capital equipment, and so on. As a result, a 100 percent rise in raw materials prices increases finished goods prices by only 7 percent.

For example, a loaf of bread contains only a few pennies’ worth of wheat. And this relationship is falling further as goods contain less in materials and more in intellectual content. A century ago, steel was a major good; producing it takes lots of iron ore, coking coal, and limestone. Today, semiconductor chips are similarly important, but they require a little silicon, plastic, and fine wire. The rest of their value is brainpower.

This year, geopolitical risks and other factors have pushed up the price of crude oil to roughly $50 per barrel and gasoline at the pump followed with a vengeance ? leaping 40 percent from December 2003 to a peak priceof more than $2 per gallon ? largely because of the lack of refining capacity in the U.S. The spike in this frequently purchased item has convincedconsumers that inflation isrampant, even though gasoline only accounts for 2.7 percent of consumer outlays.

The most widely publicized inflation metrics also contribute to the problem. For example, a congressional study found that the CPI was biased upward in several areas.

First, since the index has fixed weights, it doesn’t account for the tendency to buy more of what’s cheap and less of what’s expensive. When apple prices fall and orange prices rise, consumers buy more apples and fewer oranges. In contrast, the deflator for personal consumption in the GDP accounts is weighted by the volume of purchases in the quarter in question. This is an important reason why it records lower inflation than the CPI.

Second, the group of retail stores sampled monthly in the government survey of selling prices changes slowly over time. As a result, rapidly expanding discounters like Wal-Mart are underreported while dying full-list price mom-and-pop outlets are over-weighted.

This explains why the public and many economists are starting to worry about inflation. But, it doesn’t explain why the Trends editors are so certain inflation will remain tame and, moreover, deflation will remain the underlying force that must be managed in the coming decade.

To understand that, we need to analyze the fundamental global economic trends that are in play, and how they will affect prices in the United States in the coming years. With that in mind, we forecast the following five developments:

First, global excess capacity should keep American business pricing power in check. This, in turn, will maintain steady pressure on labor costs.

Second, the Wal-Marts of the world are another important factor in keeping inflation low. Their lower costs and lower prices allow consumers to keep getting more value for their money.

Third, robust productivity growth will be promoted by the ongoing burst of semiconductors, computers, telecommunications, the Internet, biotech, and other new technologies. This will not only lead to substantial quantitative improvements in terms of lower cost per unit, but will lead to often overlooked qualitative improvements in each unit sold. As the Sunday Telegraph reports, “The reason for this remarkable prospect is that the fundamental forces which have revolutionized price behavior ? such as the intensification of domestic competition and the spread of globalization ? are still in full spate. Meanwhile, aggregate demand has still not managed to rise sufficiently to absorb the increase in global productive capacity. One consequence is that the threat of deflation, which loomed large for markets in the middle of last year but seemed to disappear altogether this year, is anything but gone. Excluding food and energy, inflation is 1.7 percent in America, 1 percent in the UK, and 1.9 per cent in the euro-zone. If the world economy should really run out of steam, then the deflationary threat will re-emerge.”

Fourth, we expect consumer-spending growth to moderate considerably, especially since the after-tax income leaps due to the initiation of tax cuts are history. Similarly, the big bulges in defense and homeland security spending are probably over. Rising interest rates will bring rationality back to the housing market and virtually eliminate cash-out refinancings. Higher energy costs will become, in effect, a tax on consumer incomes. The resulting slower pace of consumer spending growth will be offset by accelerating business spending on capital equipment, structures and inventories. However, this is unlikely to be strong enough to sustain rapid growth at the rate we’ve seen in 2004. This moderated but sustained growth will avoid overheating the economy, so this is not likely to be a trigger for inflation.

Fifth, the money supply does not appear to pose a threat. Economist Milton Friedman’s assertion that “inflation is always and everywhere a monetary phenomenon” is good to remember as the United States faces increasing prices for some goods and much debate about how sharply the Federal Reserve should restrict money-supply growth. The money supply in the past year has grown less than nominal GDP and has been far from inflationary. In fact, the deflationary forces, apparent since 1998 and 1999 and still hard at work, lead to an era of mild, 1 percent to 2 percent annual deflation rates. If managed wisely, this will be limited to the “good deflation” of new tech-driven productivity increases and excess supply, as was seen in the U.S. in the late 1800s and 1920s, rather than the “bad deflation” of deficient demand experienced during the Great Depression and, more recently, in Japan. The fundamentals all indicate that the Fed has done a good job up to this point, and we see the current rise in inflation as being merely a brief up-tick within the longer disinflationary trend of the past 23 years.

References List :
1. To access Gary Shilling’s commentary on inflation, visit the Investors Insight website at:www.gold-eagle.com/editorials_04/mauldin 091404pv.html2. The Sunday Telegraph, September 26, 2004, "The Spectre of Deflation," by Roger Bootle. ⓒ Copyright 2004 by Telegraph Group Limited. All rights reserved.3. St. Paul Pioneer Press, September 19, 2004, "Money Supply Is Root of all Inflation," by Edward Lotterman. ⓒ Copyright 2004 by St. Paul Pioneer Press. Distributed by Knight Ridder/Tribune Business News. All rights reserved.