Friday, June 20, 2008
deflation awareness rising
Yesterday's Philadelphia Fed Survey slipped by the majority of media outlets without a single commentary on the most important part of the report: pass through of higher input costs. Just about everyone noted the prices-paid index surged to 69.3 in June, "the highest since 1980." But there wasn't enough attention paid to the ability of firms to pass through those costs.
I mean, look, we already know firms have been facing dramatically higher input costs. What is important, however, is how much of those higher input costs get passed through to consumers. Incredibly, the index for prices received actually fell in June, from 31.6 to 29.7.
The special questions in the report are worth noting. "What impact are these recent cost increases having, or expected to have, on the prices of your finished products over the next three months?" A little more than 65% expect price increases, with the average expected price change is 5.4%. Meanwhile, since the beginning of the year, the average reported price increase is just 3.8%.
And for those wondering about price increases related to delivery of raw materials, more than 70% reported experiencing any shortages or delayed delivery of raw materials or intermediate products.
Finally, from the Producer Price Indexes released earlier this week we can build this chart showing the spread between crude goods prices and finished goods prices. This chart goes back to 1987 and we can see how stretched this spread has become.
This is precisely how inflation sows the seeds for deflation. Margins will continue to be squeezed, and every day that goes by with food and energy prices elevated adds what is essentially a layer of leverage to the eventual unwind.
good analysts are trying to make a distinction between a terms-of-trade shock (such as we're seeing in oil) and an inflationary wage-price spiral. pimco's paul mcculley is one:
Most importantly, wage inflation is now only loosely connected to price inflation, in the wake of a more globally competitive, less unionized labor force. As Vice Chairman Kohn hinted, the combination of somewhat higher inflation and higher unemployment is a prescription for diminished pricing power by labor, leading to lower real wages (than would be dictated by labor’s productivity growth). Thus, unlike the 1970s, there is little wage fuel to generate over-heating aggregate demand and, thus, a sustained price-wage-price inflationary spiral.
... Deflating asset prices in a highly levered economy are a much more nefarious outcome than temporary increases in inflation in goods and services. This is particularly the case from a starting point of low inflation in goods and services (excluding those involved in the negative terms of trade shock). How so? Simple: a negative terms of trade shock and asset price deflation are a prescription for not just a recession, but a nasty one. More to the point, from a starting point of low goods and services inflation, the Fed is never far from the zero lower limit on nominal short-term interest rates, commonly known as a liquidity trap.
To be sure, the Fed must be aware of the dreaded second and third round effects, constantly checking to make sure that real wages and real profits are being eroded by the aberrantly high headline inflation. But, assuming the evidence supports that thesis, as the following graph displays, it would be an absolute folly for the Fed – or any central bank in similar circumstances – to hike interest rates in an attempt to make the negative terms of trade shock go away. By definition, it can’t. And if it tries, it will create an even bigger mess. In this case, the motto of a central bank should be the same as that of a physician: first, do no harm.
... Which means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period.
i have to agree -- and must hope, along with mcculley, that central bankers like plosser and poole are jawboning the economy out onto a plank with absolutely no intention of actually shoving it off into a sea of falling monetary aggregates. against the expectation of markets, and hopefully with the forbearance of the chinese, the lesson of 1931 must be enforced -- if it can be.
i read yesterday an excellent bit of private research regarding the end of the yuan-dollar peg and will have to write about it. suffice to say for now that the analyst's view was that the depegging of the yuan has already begun and is accelerating under the duress of rampant inflation in china as loose american monetary policy and hot money flows translate through the currency peg into their economy. the end of the debt supercycle, as the bank credit analyst called it, he put at being three to four years away, quite possibly sooner if chinese inflation continues to be problematic.
this is all another way of suggesting that the federal reserve bank may not have the freedom it would like to hold rates low and liquidity high, as it would force the kind of foreign capital flight the BCA sees as the final reckoning of debt-fuelled american aspirations.