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[TTHQ Staff]

BEING STREET SMART
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Sy Harding


Is Inflation Getting Out of the Bottle? February 18, 2005.

The Labor Department reported on Friday that the Producer Price Index (PPI), which measures inflation at the producer level, rose 0.3% in January. It was a big surprise since the consensus forecast among economists was for a decline of 0.3%. Worse, the more important ‘core rate’ of PPI (which excludes volatile food and energy prices) surged a stunning 0.8%. The latter is an annualized rate of 9.6%. The report was a shocker, and guarantees that inflation is going to be the next big topic of concern for awhile.

The fear regarding inflation is that like the famed genie, “once inflation gets out of the bottle it’s very difficult to get it back in”. Rising prices then eat into the purchasing power of money, and result in problems for the economy as the Fed raises interest rates more aggressively to try to get it back in the bottle.

One form of inflation takes place when demand for raw materials causes a shortage, so suppliers are able to raise prices (and thus their profits) without losing customers. We’ve been experiencing that type of inflation for several years, clearly visible in the sharp rise in the CRB Index of Commodity Inflation since 2001. China, India, and other ‘emerging’ countries have played a big part. Their strong economies and growing need for raw materials have been overwhelming supplies, creating shortages and driving prices up. Consumers and businesses in the U.S. and elsewhere have been experiencing that in the prices of crude oil, energy, gasoline, lumber, steel, aluminum, copper, cement, etc. And increases in the prices of those raw materials spread to higher costs in construction, transportation, and the materials side of manufacturing.

Inflation can also evolve from a strong economy that has created full employment and a shortage of workers. Businesses then raise wages to attract workers from competitors, and raise their prices to offset the higher wages. That in turn causes workers to demand even higher wages because prices of the things they buy are rising. . . . and thus what is known as wage-push inflation begins to spiral. We have not been witnessing that type of inflation, since this economic recovery has been decidedly weak in creating new jobs.

In fact until this spike up in the PPI in January, overall inflation has remained under control to an unusual degree, less than 2% annually, at least as measured by the government’s questionable Consumer Price Index.

Even when the U.S. economy became decidedly overheated in the late 1990s, inflation moved lower, not higher. That was due to the revolutionary improvements in corporate productivity in the 1990s, created by computerization, automation, and the Internet. That allowed companies to produce more work with fewer employees. They could thus absorb rises in material costs and wages without the need to raise their prices.

However at this point in the cycle all the productivity gains that can be squeezed out of computerization and automation have already taken place. That opens the playing field to the potential for rising inflation.

The Federal Reserve apparently realized that almost a year ago, when it began its current series of interest rate hikes, even though inflation as measured by the PPI and CPI was nowhere to be seen. The reason the Fed provided for the hikes was that it had cut rates so far in trying to re-stimulate the economy after the 2001 recession that it needed to get rates back up to a more normal level. However, when the minutes of some of their FOMC meetings were released in recent months it was clear that much of their discussions had revolved around concerns that inflation was lurking around the corner.

The Fed has already hiked short-term interest rates six times since last June, and in his testimony before Congress this week, Alan Greenspan made it quite clear that more rate hikes lie ahead. And that was before Friday’s surprise that the core rate of inflation rose 0.8% in January.

In his testimony before Congress, Greenspan also expressed puzzlement that long-term rates, that is bond yields, had not followed short-term rates up as they always do. Instead, bond yields had been falling (bond prices rising) even as the Fed hiked short-term rates.

It might have been that bond investors did not believe inflation would become a threat, so thought the Fed would probably not continue to raise rates. But the bond market received a dose of reality this week. Greenspan’s testimony before Congress that the Fed needs to continue raising interest rates, and then Friday's news of the spike up in inflation at the producer level in January, sent bonds tumbling, as long-term rates began to play catch-up to the months-long rise in short-term rates.

For sure, all eyes will be on the release next week of the CPI numbers for January. A sharp rise in prices at the producer level almost has to translate into higher prices at the consumer level.

A one month rise in the Producer Price Index does not establish a trend. But, it does guarantee we are going to continue to see rising interest rates.

Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.