Inflation’s Revival: Trend or Mirage?
Is inflation done playing possum?
The U.S. economy has faced a number of problems in recent years from high trade deficits to a low savings rate, but broad-based price increases haven’t been one of them.
Overall inflation has stayed remarkably tame for the last decade--an average annual rate of 2.7% as measured by the consumer price index.
But over the last two years, amid soaring energy prices and tight labor markets, the CPI and other key inflation indexes have rebounded from what were extraordinary lows.
The CPI rose at an annual rate of 3% to 4% for most of 2000, driven in large part by energy costs. But this year, even the “core” inflation rate--excluding volatile food and energy components--has surged, rising at an annualized 3.5% in the first quarter, compared with 2.6% for all of last year.
More striking has been the inflation rate in the CPI’s services components--the cost of dry cleaning, hair cuts, education, medical care and myriad other items. That rate reached 4.5%, annualized, in January and February, the highest since 1991.
With that backdrop, some analysts have begun building a case for inflation’s return on a broader scale. Under the worst scenarios, there would be a revival of 1970s-style “stagflation”--inflation without corresponding economic growth.
It’s a minority viewpoint, however. Most economists, along with the majority of the Federal Reserve Board, still believe that the chief risk to the economy is too-slow growth rather than rapid price increases. They see the recent jump in inflation as a blip.
These inflation doves make the following points.
* Prices of many commodities are flat or falling amid excess global supplies of coffee, copper, cotton and many grains, among other raw materials. Even oil and natural gas prices have come down from their 2000 peaks.
* The dollar remains so strong that imports are cheap for U.S. consumers, limiting price increases by domestic competitors.
In general, global and domestic competition is too tough to allow firms to push through price increases, except in a few isolated industries.
* Companies, spooked by falling sales and other signs of economic weakness, have begun slashing staff as though a recession has begun--a process that eventually should reduce upward pressure on wages, keeping companies’ costs low and in turn leaving consumers with less to spend.
The inflation hawks acknowledge that forecasting rising prices in such a climate isn’t an easy call.
John Lonski, chief economist at Moody’s Investors Service, calls the situation “bipolar,” meaning that there is evidence to support extreme views on both sides of the question.
Lonski, for his part, worries that inflation could make a comeback. He points to rising yields on long-term Treasury securities and the swelling U.S. money supply.
Bond investors, according to Lonski, seem to be saying not just that they expect the Fed to succeed in halting the economic slowdown but that they expect it to succeed all too well, with a new bout of inflation the result.
Normally, the longer a bond’s term, the higher its yield. For most of 2000, however, shorter-term Treasury securities were yielding more than longer-term ones, which analysts took as a sign that bond investors correctly anticipated an economic slowdown.
But when the market smells inflation, or at least faster economic growth, the Treasury “yield curve” turns steeply upward, meaning that longer-term issues have far higher yields. That’s because investors demand higher yields to compensate for the risk of holding longer-term bonds, whose value would be eroded by inflation.
And that is what has happened lately. As recently as March 1, 10-year Treasuries yielded 4.87%, compared with 4.41% for two-year notes, a difference of 0.46 percentage point. But as of Friday, 10-year yields had zoomed to 5.33%, while two-year yields were at 4.26%, for a difference of 1.07 points--a considerable steepening in the space of just eight weeks.
The money supply, Exhibit No. 2 in Lonski’s higher-inflation case, by some measures has been expanding at a faster rate than at any time in the last decade, except for a brief period after the Russian bond crisis in the fall of 1998.
Growth in the money supply goes hand in hand with the Fed’s credit-easing campaign, which has sliced two full percentage points off the central bank’s key short-term interest rate since Jan. 3--one of the most aggressive credit-easing programs ever.
All that cash has to find someplace to go. Lonski thinks much of it will go to consumption spending, which may help rekindle inflation.
That would be textbook “demand-pull” inflation: Too many dollars chasing too few goods.
Ironically, consumption-fueled inflation could get an assist from the vaunted high efficiency of the “new economy,” Lonski said.
Fed Chairman Alan Greenspan, among others, has remarked that the boom in high-tech capital spending by businesses in the late 1990s helped to keep inflation at bay.
Auto makers, for example, used new information technology to get an early reading on sales weakness last fall, enabling them to quickly and sharply cut back production. The nimble response contrasted with the industry’s historic cycles of overproduction followed by huge inventory buildups.
But Lonski believes there is a germ of an inflationary problem in the industry’s improved efficiency: Without a huge inventory, car makers may be in a good position to push through price increases, or at least hold the line on sales incentive programs, sooner than later.
The number of players in the game is being thinned by consolidation, and even some venerable brands--remember Oldsmobile?--are being phased out. At least in the auto industry, Lonski said, some semblance of pricing power may be coming back.
Yet so far, there is no real sign of it.
James Grant, editor of Grant’s Interest Rate Observer, takes a strictly contrarian stance on inflation: Prices must be about to pick up because market participants seem to be thoroughly dismissing the possibility, he said.
For example, he said, insurance against inflation is “compellingly cheap.” Treasury Inflation-Protected Securities, or TIPS, government bonds whose returns float with the consumer price index, are currently priced--relative to fixed-rate Treasuries--”as if inflation will be no more than 2% [annually] for the next 10 years,” Grant said.
The prices of other classic inflation hedges, such as gold and gold-mining stocks, are near 20-year lows, he added.
Toronto-based currency specialist Albert D. Friedberg has been arguing for months in his newsletter that inflation already is on the march but has been concealed mainly by the strength of the dollar.
That strength has stemmed mainly from the huge stock market boom and the soaring U.S. economy in the late 1990s, both of which attracted foreign investors to U.S. assets, he said.
Now, given the pummeling that the market has taken and the economy’s concurrent slowdown, the dollar is in for a fall, Friedberg said.
A significant slide in the dollar relative to other major currencies would instantly raise prices of imports, fueling goods inflation to go along with the jump in service sector inflation of the last two years.
The dollar is one of three factors that Brian S. Wesbury, chief economist at Chicago-based Griffin, Kubik, Stephens & Thompson, considers in making his decisions about inflation. The others are the yield curve and commodity prices, especially gold.
“All three should be moving at the same time for there to be inflation,” Wesbury said. To date, only the yield curve is worrisome, and despite the warnings of such observers as Friedberg, the dollar’s long-predicted swoon has yet to materialize, he said.
Indeed, so far this year the dollar has remained a powerhouse against the Japanese yen and the euro, its two main rivals.
As for the money supply, both Wesbury and Marci Rossell, head economist at OppenheimerFunds in New York, are skeptical of its value as an inflation signal.
The growth of the money supply is “in part driven by investors fleeing the stock market and going into the money market and savings accounts,” Rossell said.
Narrower measures of money, such as currency and bank reserves, have been growing at a far slower rate than money market and consumer accounts, she noted.
Wesbury acknowledged that the CPI and service sector prices in general have been rising, but he cites mismeasurement for some of the apparent inflation. He referred to Greenspan’s argument that a car today--with air-conditioning, computerized controls, air bags and other new safety features--is a different product than a car of 20 years ago, but the CPI does a poor job of taking such quality differences into account.
The same is true of the fastest-rising component of service sector inflation: medical costs.
New drugs, equipment and procedures are improving life expectancy and quality of life, Wesbury said. Sure, prices are rising, but “we’re getting more health for the money,” which isn’t reflected in the inflation calculations, he said.
Although he is worried by rising long-term bond yields, Moody’s Lonski also noted that bond buyers don’t always get it right. “They may be responding to an inflation threat that is more illusory than real,” he said.
A strong part of the dovish case is that consumer goods are globally traded as never before, with plenty of overseas production capacity. With competition so intense, the only way producers can get price increases is to have a niche or a fad product--both of which tend to be temporary, Lonski said.
“The last thing you want to do is manufacture a consumer commodity in the United States,” he said, pointing to Levi Strauss and Fruit of the Loom as firms that have struggled with foreign competition despite having globally respected brands.
Several economic reports released last week seemed to bolster the low-inflation case. Initial jobless claims rose to the highest level in five years, and newspaper help-wanted ads dropped to the lowest level since 1993, indicating that people who have been laid off may have a tougher time finding other work.
Consumer confidence has plunged with the stock market, causing many economists to predict that consumer spending will follow suit--further reducing demand and making it riskier for companies to try price increases.
“This tells me that fears of inflation are overblown, and until we get confirmation from all key areas--the dollar, the yield curve and commodities--it isn’t a problem,” Wesbury said.
*
Thomas S. Mulligan can be reached at thomas.mulligan@latimes.com.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
The Consumer Price Index Rises . . .
Inflation as measured by the consumer price index has jumped over the last two years, driven largely by surging energy prices and more recently by the rising cost of many services, including health care and housing.
Monthly percentage change in the CPI versus a year earlier
March 2001: 2.9%
*
. . . and Long-Term Bond Yields Follow
Long-term Treasury bond yields have resurged in recent weeks, even as the Federal Reserve has cut short-term rates. Higher long-term yields reflect some investors’ fears that the economy and inflation could be stronger than expected in the years ahead.
Yields on Treasury securities, by maturity, as of Friday
Maturity
3-month: 3.86%
6-month: 3.90%
1-year: 3.85%
2-year: 4.26%
5-year: 4.87%
10-year: 5.33%
30-year: 5.81%
Sources: Bloomberg News, Reuters, Times research
Hot Commodities--Until Lately
Commodity prices, led by crude oil and natural gas, rocketed in 1999 and 2000. But even energy prices have pulled back from their 2000 peaks, and many other commodities, including copper, coffee and cotton, have slumped this year amid global oversupply.
CRB/Bridge index of 17 major commodities, monthly closes and latest
Friday: 213.70
Source: Bloomberg News
