Drop the Inflation Concerns

As I've outlined before, wages tend to be the one of the better predictors of inflation (or deflation) out there as wages tend to be very sticky and stable (so when they move, it tends to mean there is a new underlying trend).

So how are wages currently holding up?

Well, earlier this week, the BLS released compensation figures for Q1 and even with negative real interest rates and multiple quantitative easings, there is absolutely no wage inflation in the pipeline. In fact, the year-over-year change in nominal wages came in at just 1.3% at the end of March and 0% over the last six months, the lowest since the crisis and below the rate of inflation.

Even more concerning (to me) is that these figures are as of March, before business sentiment took a turn for the worse on renewed European concerns.

With no inflationary pressure and limited growth potential, a low yielding Treasury bond almost appears justified.

Source: BLS, BEA, Fed

Will the US be Importing Deflation?

Bloomberg details:

The import-price index climbed 0.7 percent, the first increase in four months and followed a 0.5 percent drop in October, Labor Department figures showed today in Washington. Economists projected the gauge would increase 1 percent, according to the median forecast in a Bloomberg News survey. Prices excluding fuel decreased 0.2 percent for a second month, the first back-to-back drop in more than a year.

Oil prices may have reached a plateau this month, indicating increases in the cost of imported goods may moderate as slowing growth from Europe to Asia and a strengthening dollar hold down prices. Federal Reserve policy makers yesterday said they expected inflation to slow and reiterated their pledge to hold the benchmark rate “exceptionally low” at least through mid-2013.

The below chart outlines the longer term trend in imported inflation. Over the past three months, the price of imported goods (excluding petroleum) has declined for only the third time since 2005 (six month figure is now flat), while the twelve month change is turning lower (below 4%) after it peaked at over 5% as recently as September.

Source: BLS

European Expectations and the Price of Gold

You never want to read too much into any short-term trend, but take a look today's market performance, as well as the "correction" we've seen across asset classes since spring / summer peaks and notice which assets have done well (high quality income producing bonds) and which have done poorly (equities, non-US currencies, commodities, AND gold). I highlight gold because over the past three years risk-asset sell-offs have broadly been met by strong bids for Treasuries and gold, but today's performance and the drawdowns indicate it may be losing that flight to quality bid.

Daily Performance (December 12th, 2011)

Drawdown from 52 Week High

As Eddy Elfenbein's gold model outlined (further optimized by Willem Weytjens), gold has broadly done well in low (or negative) real interest rate environments. In fact, should inflation run at its historical levels the next two years, Willem's revised model calls for $4000+ per ounce gold in the next few years.

Yet, gold is down about 12% from its recent peak. One possible reason is the concern over Europe. My own thinking... how unlikely is it that things get worse, impacting global aggregate demand and the financial system more broadly? In that case, how improbable is disinflation or deflation, which in turn would mean these low nominal rates may actually move a lot higher in real terms.

Source: Yahoo

Capacity Utilization vs. Inflation

Marketwatch details:

The output of the nation’s factories, mines and utilities rose 0.7% in October, the Federal Reserve said Wednesday in another sign the manufacturing industry is still expanding.

The October gain was the biggest since July and was stronger than the 0.4% increase expected by analysts.

Source: BLS / Federal Reserve

Inflation (Not Yet) a Concern

The AFP details:

Inflation roared back in July at the fastest pace since March, squeezing consumers just as the economy appears to be veering toward recession, government data showed Thursday.

The inflation numbers came amid a batch of worse-than-expected data on the jobs market, manufacturing and housing, and as US and European stocks markets plunged on rising recession fears.

A sharp rebound in gasoline prices and continued increases in food prices drove last month's inflation surge, the Labor Department said Thursday.

While I am concerned with excessive inflation over the longer term if the Fed determines they should pursue an "inflation or bust" policy (the alternative as I see it is painful deflation... a lose lose if you ask me), the latest figure does have me less concerned with inflation over the nearer term. As can be seen, the higher than targeted inflation level is almost solely due to higher crude prices feeding into gas prices. This has already reversed in part this month.

Source: BLS

Still Too Much Capacity

The below chart shows that capacity utilization in the system is slowly recovering, but remains remain very low.



This in part explains why core inflation remains muted, even with the recent commodity spike.

Source: Federal Reserve / BLS

Capacity and Inflation

My view yesterday of inflation.

My view? Unless we see a pickup in employment (we may), all the stimulus (fiscal and monetary) will just feed into the rise we are seeing in commodities, not overall price levels. If corporations / individuals don't see a corresponding pickup in profits / income, then all this means is less money for non-core items. The result? A split between headline and core inflation. Just what we have seen thus far...

Capacity utilization strongly (in my opinion) supports this view. While excess capacity has declined (a lot) since the lows, it is still very low relative to historical levels WITH THE EXCEPTION OF MINING (in the U.S. at least - globally levels may be different, though unlikely.



Result? The potential for commodity and core inflation to remain bifurcated going forward.

Source: Federal Reserve

Wages and Inflation

Paul Krugman details the connection between wages and inflation:

I get a fair number of comments to the effect that worries about deflation are all wrong, look at commodity prices. I’ve tried in the past to explain why we should focus on sluggish, sticky prices, not volatile prices like commodities — hence core inflation. But let me add another point: arguably the stickiest, sluggishiest prices are those of labor. So why not focus on wages?

Source: BLS

Inflation is Off the Table

The Business Financial Newswire reports:

Nonfarm business sector labor productivity increased at a 6.9% annual rate during the fourth quarter of 2009, the US Bureau of Labor Statistics reported today (4 March). The gain in productivity reflects a 7.6% increase in output partially offset by a 0.6% increase in hours worked.

From the fourth quarter of 2008 to the fourth quarter of 2009, productivity increased 5.8% as output declined 0.2% and hours fell 5.7%.The annual measure of productivity increased 3.8% from 2008 to 2009.Unit labor costs in nonfarm businesses fell 5.9% in the fourth quarter of 2009, the result of productivity increasing faster than hourly compensation.

So productivity up and real compensation trending down = unit labor declining massively in Q4.

Unit labour costs decreased 4.7% from the same quarter a year ago, the largest four-quarter decline since the series began in 1948.

The relevance? Well, if the past is any indication of the future (in this case I believe it is), then inflation is not a problem (at least in the near future) and the most recent period is simply noise from the whipsawing of commodity prices and massive monetary / fiscal stimulus.

Source: BLS

More on Wage Inflation

Earlier this week EconomPic detailed that now is not the time to worry about inflation.

Commodity driven inflation absolutely can pose major problems, but it is usually wage inflation that feeds into any out-of-control inflation spiral. Thus, keep the following in mind when thinking about whether inflation will be a major issue over the near term horizon.

The "following" was a chart of the change in compensation over the past decade. In response, reader Boatman commented:

in the largest inflationary period in US in modern times wages were flat (78-82). i was there. tomorrows problem is todays opportunity. this is gold buying time,find the bottom & pull the trigger.

Memories are a funny thing because that is just not true. Inflation fed through wages until Volcker stamped it out by dramatically raising short-term interest rates.



That said, I personally think gold can (and will) go higher, but for different reasons (see here and here).

Source: BLS

Don't Worry About Inflation... For Now

Commodity driven inflation absolutely can pose major problems, but it is usually wage inflation that feeds into any out-of-control inflation spiral. Thus, keep the following in mind when thinking about whether inflation will be a major issue over the near term horizon.

Marketwatch reports:

The costs of employing a worker in the United States moderated in 2009 to the slowest pace on record, the Labor Department reported Friday.

For the past calendar year, the employment-cost index increased 1.5%, the slowest rate of increase since the government began tracking the data in 1982. This is down from a 2.6% increase in 2008.

Wages increased 1.5% in the past year. Benefit costs rose 1.5%. These are both record lows.

Source: BLS

Where are Long Bond Yields Going: Late 70's / Early 80's Edition

My comment in my post Where are Long Bond Yields Going?:

But the money shot is that when the yield curve has been VERY steep (i.e. more than 4%) the Long Bond has rallied in all cases (19 out of 19 times) over the next year.

Received the following response by reader Henry Bee (bold mine):

This is a great observation! One caveat though: the data is taken during a period of time where the 30-year bond yield DECLINED consistently (the data was from 1986-2009). This observation would be more reliable if it includes 1960-1980 where the 30-year bond yield ROSE.

If we're experiencing a regime change today, then the relationship likely won't hold.

And he is correct that rates rose DRAMATICALLY from the late 1970's through the early 1980's (the Long Bond only started trading in 1977). Looking at the data from 1977-1985 (i.e. the time frame that took place before my post), we have the following:

Note that the yield curve was only as steep as it is now (i.e. more than 4%) for a brief period in 1982 and the steepness (i.e. spread between 30 Year Treasuries and 3-Month T-Bills) was much more volatile during the above time frame than since. We can also see the spike in this steepness from April - October 1980 when 3-Month T-Bill rates dropped dramatically (the data is from the Federal Reserve), only to rise within 6 months. As an anonymous reader explained:

In 1980 there was a mini credit crunch following, I believe, a speech by Pres. Carter about not using your credit card. The Fed eased in the spring, pushing rates down from the high teens to the high single digits. They reversed course by the end of that summer. You can see it in both the consumer credit data and in the effective Fed funds rate.

And below we show an updated chart showing the steepness of the yield curve on the x-axis and the change in the 30 year yield, one year forward, on the y-axis for the 1977-1985 time frame (each point represents an end of month figure) with that 6 month window broken out in red.

What do we see? I would say the overall theme is unchanged. When the yield curve is VERY STEEP rates move down in more cases than up. When Long Bond rates were rising dramatically, it was in a number of cases led by a rise in the short rates (in response to inflation and/or an attempt to stomp out inflation), which resulted in the yield curve to be inverted. The outlier was that odd period from April 1980 - October 1980.

In summary, when the market historical priced-in inflation into long yields, it typically also priced-in inflation in short yields. The idea that short-term deflation is a potential outcome, while at the same time long-term inflation is a potential outcome is an outlier event.

In other words, history can not necessarily help us with what to expect.

UK Weakness and Disinflation

In the face of strong numbers coming out of China indicating much of the world may be coming out of the global recession faster than anticipated, the dollar isn't the only currency selling off. In fact, the Pound has been selling off at a faster clip due to some serious relative weakness brewing out of the United Kingdom. BBC News details:

A key measure of inflation has fallen to its lowest level since September 2004, official statistics show, further weakening the value of sterling.

The Consumer Prices Index (CPI) dropped to an annual rate of 1.1% in September from 1.6% in August.

Meanwhile, the Retail Prices Index (RPI) inflation measure, which includes mortgage interest payments and housing costs, fell to -1.4% from -1.3%.

The pound fell 0.5% against the euro to a six-month low of 1.0628 euros.

It also fell to a five-month low against the dollar of $1.571, though pulled back against both currencies later.

Source: Stats.Gov.UK

Importation of Deflation Reversing

The WSJ reports:

U.S. import prices rebounded last month on the back of higher energy prices, following a brief dip in July.

Import prices climbed 2% in August from the month before, the Labor Department said Friday. That followed an unrevised 0.7% decline in July, the first drop of the year. Economists surveyed by Dow Jones Newswires had expected a 1.2% gain. Still, import prices remained down 15% compared with August 2008, following a 19.2% annual decline the month before that was the biggest drop since the index was first published in 1982.

Petroleum import prices jumped 10.5% in August from July -- the sixth gain in seven months -- but were down 38.1% on the year.

Excluding petroleum, import prices were 0.4% higher from July, though remained down 6.5% from August 2008.

Source: BLS

Importing Deflation?

Markets remain volatile, thus while there is concern that a weak dollar will result in commodity prices once again rising, if green shoots continue to shrivel than import prices will likely reverse the recent ascent. Marketwatch reported on Friday:

Prices of imported goods rose 3.2% in June, the largest increase since November 2007 and the fourth consecutive monthly gain, as petroleum prices shot higher, the Labor Department estimated Friday. Analysts polled by MarketWatch had expected the import price index to rise 2.5% in June. Despite the monthly gain, import prices were down a substantial 17.4% in the past year.

In May, the imports index rose a revised 1.4%, compared with a prior estimate of a 1.3% gain. In June, imported petroleum prices increased 20.3%, the largest monthly gain since April 1999 and the fifth consecutive monthly increase. However, the petroleum imports price index is down almost 46% over 12 months.

Since the June 30th date in the above chart, oil has dropped $14 a barrel (~20%), thus expect the recent rise in non-manufactured goods to reverse course in July.

Source: BLS

I'm Impressed with the Fit...

I posted the below update directly to yesterday's post on Capacity Utilization vs. CPI, but as it was late in the day, had already moved down the blog, and involved the questioning of the validity of one of my beautiful charts, here it is again with a bit of additional analysis.

Scott Grannis of Calafia Beach Pundit apparently reads my blog, which is cool (for those that missed my earlier post, he is my favorite blogger to disagree with). He posted on the same topic of capacity utilization vs. CPI (bold mine). Here is an excerpt:

As a counterpart to my interpretation of events, I suggest you have a look at a similar post on EconompicData which has a chart that paints a very different picture than my chart. He argues that the change in capacity utilization has always been a good predictor (by 6 months) of inflation. I'm not all that impressed by the fit of the two lines on his chart (sometimes they move together, and sometimes they don't), and I don't think there is a logical reason to expect a strong fit in the first place.

Here is the chart from yesterday which is referring to...


Before I defend the chart, I must defend myself. I never said capacity utilization has ALWAYS been a good predictor of CPI (that would be foolish). The only thing I know that "always" follows something is my interrupting someone after I've had a few beers. I think "generally" would be the term I would have used.

But more important to the credibility of EconomPic is that Scott is "not impressed" by the "two lines" in my chart. To me the relationship seems strong, but let's see what the math shows.

Drum roll please.....

The monthly "lines" in the chart above have a correlation of 0.533 from July 1982 - November 2008 (the last date I have for CPI due to the 6 month lag). Why July 1982? Because I like to make my numbers more impressive (the correlation from June 1982 was "only" 0.504 and from August was "only" 0.522).

And over 1, 5, 10, 20, and 30 years? Well, here's the chart...


Our back and forth reminds me of an article I just read over at Time.com, Yes, I Suck: Self-Help Through Negative Thinking. In the article they detail a study, which I feel is at the heart of our argument and the need for Scott to say that "he isn't impressed by the lines on the chart" and my need to update not only my original post, but add this one as well.

The study's authors, Joanne Wood and John Lee of the University of Waterloo and Elaine Perunovic of the University of New Brunswick, begin with a common-sense proposition: when people hear something they don't believe, they are not only often skeptical but adhere even more strongly to their original position. A great deal of psychological research has shown this, but you need look no further than any late-night bar debate you've had with friends: when someone asserts that Sarah Palin is brilliant, or that the Yankees are the best team in baseball, or that Michael Jackson was not a freak, others not only argue the opposing position, but do so with more conviction than they actually hold. We are an argumentative species.

But, can anyone reasonably argue, whether or not they like the data or analysis, that this isn't at least a semi-strong correlation?

I'm guessing Scott may have something to say.

Source: Federal Reserve, BLS

Capacity Utilization vs. Inflation

Yesterday, we took a look at the recent jump in used car prices and the impact the "drivers" (pardon the pun) of that jump have on inflation. In short, the cause of the jump (people drive their cars longer, thus used car supply is down) has also had a substantial impact on new car sales (they're down). This reasons that factories producing NEW cars will have extra capacity (they do), which will eventually "drive" down their prices.

And this phenomenon can be seen in historical data of capacity utilization for the broader economy and CPI. When capacity utilization has shifted, CPI has followed with a roughly six month lag.



Interesting (to me) is that it hasn't been the absolute level of capacity utilization that has impacted the "going" CPI rate, it has only been the change in that level that has. In other words, if capacity utilization stabilizes or increases in the near term, then inflation is likely to stabilize at this lower rate or come barreling back sooner than I had previously thought.

But before then, expect the negative CPI prints to continue.

Update:

Scott Grannis of Calafia Beach Pundit reads my blog (again, he is my favorite blogger to disagree with). He posts on the same topic and says (bold mine):

As a counterpart to my interpretation of events, I suggest you have a look at a similar post on EconompicData (this post) which has a chart that paints a very different picture than my chart. He argues that the change in capacity utilization has always been a good predictor (by 6 months) of inflation. I'm not all that impressed by the fit of the two lines on his chart (sometimes they move together, and sometimes they don't), and I don't think there is a logical reason to expect a strong fit in the first place.

Here's why: Idle resources and high unemployment may indeed depress the prices of some things, and may cause some workers to accept lower wages. But inflation is a condition in which all prices rise, not just some. So whatever reduction in price pressures we see as a result of rising unemployment and falling capacity utilization are not necessarily going to result in all prices falling. Sometimes a decline in capacity utilization will result in falling inflation, but not always. What's really driving inflation is monetary policy, as I've argued above.

The important thing to focus on today is that while the level of economic activity overall has fallen rather significantly from where it was a year ago, the amount of money circulating in the economy has risen significantly. Money is now abundant, whereas goods and services are relatively scarce. When the public's demand for money declines—something I think may already be underway—then we will have a surplus of money and a reduced supply of goods and services, and that is the classic recipe for rising inflation.

Shocker... I don't agree with Scott. His argument that the amount of money in circulation is what matter runs counter to my belief that credit is what unfortunately matters to prices in the U.S. (for a GREAT read on why I believe 'Credit Money' is what matters rather than 'Fiat Money' see Roving Cavaliers of Credit by Steve Keen).

But more important, Scott is "not impressed" by the "two lines" in my chart. Lets see what the math shows. Drum roll please..... the "lines" in the chart above have a correlation of 0.533 from July 1982 - November 2008 (the last date I have for CPI due to the 6 month lag). Why July 1982? Because I like to make my numbers more impressive (the correlation from June 1982 was "only" 0.504 and from August was "only" 0.522).

0.533 correlation over 27+ years?!?! Pretty darn IMPRESSIVE if you ask me...

Source: Federal Reserve / BLS

I'm Back... What I'd Miss

Got to love technology...

First what I didn't miss... with only around 30 minutes of I-Phone browsing per day over the past 2+ weeks, I was able to keep in touch with daily events and even post / comment on them via the social-networking site formally known to me as "stupid / waste of time / I don't get it" and now known as Twitter (I'm saving the phrase "pretty f'n cool" once I truly understand all its uses).

Not only did it provide a way for me to waste time posting daily economic / financial / interesting articles (i.e. my version of links of the day), but it allowed me to waste time reading about other economic / financial / interesting articles AND world events (i.e. the gripping situation in Iran) in real time. For those interested I will continue to post links to items I don't feel like using a full post on at www.twitter.com/EconomPic (you will also be able to view the most recent 7 twitter posts (I still don't like the term "tweets") on the upper right portion of the home page.

So, what did I sort of, but not fully, miss? Below is a chart of the changes in a few major asset classes (stocks, bonds, commodities) and well as the percent change in the 10 year yield (yes, a percent of a percent).



Sticking out like a sore thumb was the continued sell-off of in longer dated Treasuries. One of the main reasons (along with inflation expectations / less recycled dollars from a decreased current account deficit) is this week's massive issuance. Interest Rate Roundup with the details:

The Treasury Department just announced how much debt it's going to sell next week. Get a load of these figures: $61 billion in T-bills. $40 billion of 2-year T-notes. $37 billion of 5-year Notes. And $27 billion of 7-year notes. That's good for a record $165 billion of debt, the most sold in any week ever, driven by increased sales of five-year and seven-year debt. Long bond futures are off about 1 23/32 right now, with 10-year note yields up 11 basis points to 3.8%.

My personal view is that this may actually present a buying opportunity (what you talkin' about Willis?). In an environment that has continued to deteriorate (i.e. less worse isn't better, though the improvement in continuing claims was striking), you can currently collect a close to 4% REAL coupon (i.e. inflation is currently non-existent and the likelihood of inflation over the medium term is in my mind decreasing, though market expectations certainly disagree).

Why decreasing? Well, along with limited / no opportunity for workers to demand increased wages, take a look at the chart below using data from the Federal Reserve detailing the difference between current capacity and average capacity from 1972-2008.



What this shows is that there is massive excess capacity to manufacture goods (durable and non-durable) ready to meet any increase in end-user demand. This means the marginal cost to produce an additional good is minimal. Thus, unless demand increases dramatically in the short-run, inflation should be in check (all else equal).

As an aside, Paul Krugman detailed in a recent lecture (here) that this also poses is a problem to the recovery story. One of the automatic stabilizers in an economy is that at some point new investment is needed (either to replace old capital stock or because new technology is that much better). In this cycle, there is MASSIVE amounts of excess capacity that needs to be filled before any new investment will be put in place (i.e. for the new factory or equipment).

While I do believe in the inflation story over the long term (my view is a lot of this excess capacity will fall at some point in the future, not due to increased demand, but due to decrease in supply with companies going out of business), investors in general use very short-term information and have a VERY short memory. If we see continued negative PPI and CPI prints over the next 3-6 months, I think there is a strong possibility that the inflation story will become the deflation story. In addition, if equity markets lose even a portion of the massive gains (is half the rebound of out the question?) they've seen over the past 3 months, expect investors to once again flock to the "safety" of Treasuries.

Can We Inflate Our Way out of this Mess?

Three ways the U.S. can decrease the level of nominal debt as a percent of GDP:

• Default (not going to happen... at least while we still own the printing press)
• Increase productivity (and GDP), while paying down or maintaining the debt load
• Inflate our way out of it (decreases the value of debt in real terms)

Of the three, in theory, inflating our way out of it will be the easiest, as it does not require true real economic growth. In Wolfgang Munchau's recent FT article 'We Cannot Inflate our Way out of this Crisis' he states that it may not be all that easy after all. Wolfgang details:

Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust. In the end, workers would demand wage increases of at least 6 per cent each year and companies would strive to raise their prices by that amount.

Yves at Naked Capitalism agrees that it is a challenge, but possibly due to a different reason:

You may have noticed a crucial assumption...."workers will demand wage increases." Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a a tight labor market make.

Stagflation was seen as impossible until it took place. I wonder if we could wind up with rising bond yields due to concerns about large fiscal deficits, with a lower rate of goods inflation due to the lack of cost push (wages are a significant component of the cost of most goods, save highly capital intensive ones). In fact, we could see stagnant nominal wages with mildly positive inflation, which means wage deflation. If that was also accompanied by high yields, you would have much of the bad effects of debt deflation per Irving Fisher (high real yields and reduced ability to service debt) since real incomes would be falling in the most indebted cohort.

The key point is that in the current environment, workers have no power. While we all know about the spike in the unemployment rate, the other side of the story is the cliff dive in the number of new job openings. The odd thing is I first became fully aware of this information in Sunday's NY Times article Bleak Picture, Yes, But Help Still Wanted that made the case that the market was actually FULL of opportunity.

Consider that in March, nearly 700,000 jobs disappeared. But now consider this: At the end of March, there were 2.7 million job openings. What tends to get lost in the data picture is that just as some companies are laying off workers, other companies are hiring. In fact, the business world is changing at such a dizzying rate that some companies are cutting and hiring workers at the same time.

Uh.... no. 2.7 million is down from 4.8 million openings as recent as the Summer of 2007; when 6 million less people were unemployed. In other words, the number of job openings has halved, while the number of those unemployed has doubled. That is not "bleak"... that is frightening.



This in turn has pushed the number of unemployed, as a percent of job openings, up more than three-fold to 500%. Yes, for each opening... 5 people want that job. That my friends is why, as Yves points out, workers don't have ANY bargaining power.



Thus, the concern I have is that inflation won't be driven through via wage increases (where at least workers salaries are keeping up), but by a spike in the price of commodities. If inflation concerns = dollar concerns = commodity spike, then that impossible stagflation may be possible once again.

Source: BLS

United Kingdom Deflation Alert

Bloomberg reports:

U.K. inflation slowed more than economists forecast in April to the weakest level in 15 months as the recession undermined price pressures in the economy.

Consumer prices rose 2.3 percent from a year earlier, the Office for National Statistics said today in London. The median forecast in a Bloomberg News survey of 28 economists was 2.4 percent. The retail price index measure of inflation dropped an annual 1.2 percent, the most since records began in 1948.

Source: Statistics.Gov.UK