Financial Market Commentary

Posted by Kevin Reinecke.

Large swings in inflation have affected the United States economy throughout its history.  The boom of the “Roaring Twenties” through the banking crisis of the 1980s reflect some of the most volatile periods of inflation America has experienced.  A tighter grasp on the U.S. Monetary system and restored confidence in the banking industry stabilized inflation between 0% and 5% over the last 25 years.

Source:  gocurrency.com

That period of stable prices may be at an end.  As inflationary pressures begin to mount due to several economic factors, including the devaluation of the U.S. dollar, increased oil prices and changes in Chinese labor laws, there seems to be only one ordinary solution: Raise rates to derail a significant wage-price spiral similar to the 1970s. One problem: these are not ordinary times.  In fact, while some economists argue in favor of battling inflation, other economists articulate the need to increase aggregate demand while holding the unemployment rate down.  Within this framework, only one path may be chosen. The question remains: which path? (Read more at RGE Monitor.)

The low interest rate regime of the 21st century has fueled persistently rising prices worldwide.  Inflation in China was 8.7% in May-08 and 27% in Vietnam in June-08.  The U.S. has posted an inflationary rate near 4% over the last 2 years.  With low interest rates and small increases in wages, this rate of inflation has led to both real interest rates and increases in personal income running at negative rates in the U.S.  The globalization of the U.S. economy makes inflation in developing countries a more significant force here at home.  While some economists argue that inflation is not a problem until costs AND wages rise, most workers would argue that accepting inflation is a better alternative than costs rising with no increase in wages.  In the 1970s, rates had to be increased into the 20% range before the rate of inflation moderated.  Reaching double digits in interest rates may not be necessary, but JP Morgan Chase & Co. calculated the real interest rate across emerging countries near 2.3%, compared to 3.7% a year earlier.  European Central Bank President Jean-Claude Trichet believes there is risk of inflation “exploding” if central banks are not quick to act.  As a result, the ECB recently raised its benchmark lending rate to 4.25%.  While rates continue to be low across the world, David Hensley, Director of Global Economic Coordination for JP Morgan, explains that the Fed is hundreds of basis points away from implementing a restrictive policy on inflation. [1]

The following graph illustrates the relationship between the Consumer Price Index and Retail Sales during the 1970s. 

The graph provides insight into inflation’s negative effect on retail sales and the economy. The strong correlation suggests that as inflation continues to grow, consumers feel the brunt of inflation.  Although companies must contend with the rising cost of doing business, including transportation, raw materials and the devaluation of the U.S. dollar, the result of weakening purchasing power falls most directly on U.S. consumers.   In fact, rising inflation may lead to increasing revenues for many businesses.  For example, many companies are experiencing price increases, but are maintaining consistent gross margin rates.  For sales and profits to decline, companies would have to see reduced traffic and transactions by nearly the same amount as the price increases passed on to consumers.  Examples of this include Colgate-Palmolive and British Petroleum (BP).  Colgate-Palmolive announced that it is experiencing soaring costs for energy and raw materials.  As a result the company increased prices by an average of 4.5%.  In addition to the price increases, Colgate-Palmolive reported that the weakening dollar accounted for 7% of the 19% quarterly jump in profit.  [2]

Similarly, BP recorded profits that were $400 million higher than normal for an operating quarter.  Officials note that despite high prices, “companies found it easier than anticipated to pass high prices on to motorists.”  [3]

How great a risk is long-term inflation? Some members of the Fed are currently downplaying the risks.  In fact, a Financial Times report suggests that inflation is expected to continue through 2008 before leveling or falling in 2009.  As economists continue to search for a balance between inflation, unemployment and sluggish economic growth, the Fed has decided that its next move in rates will be up.  Although this is expected to have an adverse effect on the housing market, a tighter monetary policy should impact the U.S. economy favorably in the long term.  Fed Chairman Ben Bernanke recently re-affirmed that the Fed is “committed to achieving medium-term price stability.”  This balancing act is necessary to try to limit inflation without sending the U.S. economy even deeper into financial trouble.  [4] 

Announcements of future intentions to increase rates may be more symbolic than real, but managing inflation continues to be at the forefront of central bankers’ minds.  U.S. central bankers are continuing to search for a balance between inflation and other economic risks.  The Financial Times explains that such a rate increase leaves the Fed “divided.”  As much as it’s ever been, The Fed is torn between battling inflation via rate increases or keeping rates low to perk up aggregate demand and minimize unemployment.  [5]   

The U.S has reached a pivotal point in the inflation-vs.-growth decision-making process.  Americans are struggling, inflation is a real concern and consumer confidence is low.  The Fed is under pressure to deliver extraordinary results during these unusual times.