A Little More Inflation--in Right Spots--Could Be Good

Do you hate and fear inflation? The Federal Reserve Board thinks you do. Which is why, for the last 16 years, Fed policy has treated inflation as Public Enemy No. 1 and has hammered it down to a barely noticeable 3%-per-year since 1991.

If that’s been a great victory for the working person, however, millions of them don’t know it. Prices for goods may not be rising much, but neither are wages for many people, nor the value of their principal asset--their home.

For many Americans, the truth is that a little more inflation--in the right places--might be welcomed, not cursed.

Does that sound like heresy? It does to financial markets. Last week, long-term bond yields reached their highest levels in eight months and stocks tumbled as Wall Street was confronted by its historical inflation nemesis--the commodity markets. When prices of everyday raw materials like wheat, oil, coffee and cotton rise sharply, as they have this year, stock and bond markets see red.

In part, Wall Street’s hatred of higher commodity prices reflects a natural fear of any significant inflation, given how the latter automatically reduces the value of financial-market returns. But there is also a jealousy issue here: If “hard assets” such as commodities or real estate become alluring investments again, as in the 1970s, they might displace stocks and bonds, which have had investors’ undivided attention since 1982.

By Friday, inflation hysteria had abated, allowing bond yields to ease and stocks to rebound a bit. The government’s gauges of inflation at the wholesale and retail levels for March showed bigger-than-expected increases. But those were skewed by higher food and energy prices that economists regard as probably temporary. Removing those sectors, the reports show little inflation in March at the wholesale level and only a modest increase at the retail level.

In other words, situation normal? Some analysts don’t think so. Although economists’ consensus estimate for consumer-price inflation is a mere 2.7% for 1996 and 2.8% for 1997, according to Eggert’s Blue Chip Consensus letter in Sedona, Ariz., some Wall Street pros think their peers have been lulled into complacency.

Nobody is talking about a return to the madness of the late 1970s, when annualized inflation topped 13%. But the potential for upward pressure on inflation from the Fed’s cherished 3%-or-less level is apparent, not just in soaring commodity prices but in the global economy’s resilience this year despite higher interest rates, and in workers’ growing anger over what they see as stagnant wages at a time of nearly “full” employment.

What’s more, governments worldwide are feeling pressure to spur growth and job creation, even if that means an increase in inflation, argues Ken Goldstein, economist at the Conference Board research group in New York. “If we’re talking about a little bit more inflation, not for its own sake but as a signal of higher wages, more jobs, more [economic growth]--there is a constituency that says, ‘Why not?’ ” says Goldstein, who expects annual U.S. consumer inflation to approach 4.5% within a few years.

On the commodity side, higher prices for many basic raw materials aren’t a mere fluke. Rather, rising prices show that demand is finally running up against the reality of years of inventory shrinkage worldwide in such commodities as wheat, uranium and silver.

“Inventories remain tight across almost all major commodity markets,” says Steve Strongin, commodity analyst at brokerage Goldman, Sachs & Co. in New York.

In the case of some commodities such as oil, supply isn’t really a problem. Indeed, a major reason for the surge in oil prices this spring is simply that refiners had put off purchases for too long, waiting for Iraqi oil to begin flowing again. (Iraq and the United Nations are still talking.)

Yet for other commodities, especially grains, it won’t be so easy to relieve price pressures, Strongin contends. “Crop shortages are normally alleviated by shifting land from one crop to another and rapidly increasing the supply of the shortage crop,” he says. “In the current situation, with nearly all crops in shortage,” that is much more difficult, he says.

But do higher commodity prices necessarily translate into higher prices for goods at retail? The short answer is no. Ray Worseck, economist at brokerage A.G. Edwards in St. Louis, figures that raw materials account for less than 10% of the cost of finished goods, as measured by the U.S. consumer price index.

No wonder that cereal giant Kellogg Co., asked about the effect of higher grain costs, says it hasn’t raised retail prices since 1994. As for the future, a spokesman says merely, “Our goal is to remain the value leader in our category.”

That is the biggest argument against the reemergence of consumer inflation: For competitive reasons, many firms can’t or won’t raise prices. And thanks to productivity gains in the 1990s, the result of heavy corporate investment in new equipment, many companies have been able to eat any raw-material price hikes without sacrificing profitability or raising prices.

Whether that can go on is the question. The dangerous thing about commodities today is that they have begun to get investors’ attention, besides the usual attention of commodity consumers.

“You’re going to see a reversal, where commodities are going to become attractive investments relative to paper assets” like stocks, predicts Bob Buttner, co-manager of the Lindner Bulwark fund, a St. Louis-based mutual fund bullish on commodity markets. If he’s right, the pressure on companies to pass through commodity-price hikes will become more urgent.

But the force with the biggest potential for pushing inflation is wage growth. There are only the slightest hints so far that wages are increasing faster than the 2.9% average annual rate of recent years. With the surprising job growth in the U.S. economy so far this year, however, some economists think the next step is for many workers to begin seeing bigger raises. That would, in turn, raise companies’ costs and give people more spending power--two necessary ingredients for a modest rise in inflation overall.

Will the Fed, and the bond market, permit faster economic growth that might raise inflation from, say, 3% to 4%? Most economists are dubious. But sometimes the economy has ideas of its own. The great inflation of the past 10 years has been in stock prices and executive salaries. Maybe it’s not so farfetched to imagine a little less inflation in those things and a little more in hard assets and in the average worker’s paycheck.