A danger of inflation: The misallocation of resources on the way to sustained price increases (an explanation of the mission of Inflation Watch)Posted: May 31, 2011
In January of this year, Professor Russ Roberts of George Mason University invited fellow economics professor Don Boudreaux to address “Monetary Misunderstandings” on the weekly podcast “EconTalk.” From the synopsis:
“Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.”
I was most interested in the discussion about the definition of inflation because I understand the importance of maintaining technical and economic clarity on this topic for “Inflation Watch.”
Boudreaux first deferred to Milton Friedman’s famous empirical proclamation “inflation is always and everywhere a monetary phenomenon” and lamented that the economics profession no longer defines inflation as an increase in the money supply. Now, inflation represents a sustained increase in the average price level in the economy. Inflation is not simply any increase in price; Boudreaux complained that this definition is a common misconception of non-economists. However, he acknowledged that he personally thinks inflation’s largest threat is the process by which price increases become sustained. This process features uneven injections of money into the economy, causing specific and identifiable distortions in the economy that lead to a misallocation of resources. (Roberts somewhat disagreed as he expressed much greater fear of hyperinflation).
Bill Fleckenstein first taught me this notion that increases in the money supply distort specific areas of the economy. Such distortions can morph into bubbles, inflation’s ultimate misallocation of resource (capital). Bubbles can occur without ever tipping the economy into an inflationary cycle via official government statistics. So, it is very easy, for example, for the Federal Reserve to do nothing about soaring prices in an important sector of the economy and instead simply plan for the ultimate clean-up of the bubble’s aftermath. In recent history, the disastrous wakes of bubbles have forced the Federal Reserve to resort to easy money policies that invariably help fuel the next bubble. (Fleckenstein famously reviews this process and a lot more in “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.”)
Through Inflation Watch, I identify news of price increases not because any one price hike defines inflation; as noted above, this approach is technically incorrect. Instead, these stories offer clues that potentially can uncover the misallocations of capital that flag inflationary forces may be developing. I am trying to piece together a mosaic of economic activity that may provide early indicators of inflation well ahead of the moment that government statistics show it or the moment the Federal Reserve officially announces an inflationary process is underway.
The general context is important. We are currently experiencing an extended period of easy money policies in most of the globe’s developed economies. Presumably, this money must go “somewhere” at some point in time. Financial markets are the perfect conduit for easy money; investors and speculators alike will flock to those parts of the economy that promise some protection against the devaluation of currency and/or profits from inflationary pressures. (Boudreax and Roberts never directly addressed the enabling influence of financial markets for transmitting inflationary pressures). I have argued in previous posts that the most favorable hosts for easy money are where demand is particularly robust and supply may be constrained or stressed. Today, commodities represent a perfect storm for global easy money policies. So, many of the recent stories in Inflation Watch have focused on commodities and industries dependent on consuming commodities.
The Federal Reserve’s current bias toward inflation shows because the Fed has demonstrated relatively quick action to thwart the perceived threat of deflation. The specter of the Great Depression always looms large. Recall that after the dot-com bubble burst, Greenspan cited the threat of deflation as a prime reason for aggressively loosening monetary policy. The crash of the housing bubble of course generated an even more aggressive policy of monetary easing given housing’s importance to the overall economy and consumer spending. The Federal Reserve’s recent success in averting deflation certainly adds confidence in applying easy money policies, much to the likely chagrin of devout deflationists. Meanwhile, the Federal Reserve has also made it clear that it will not act against inflation until price increases (or the expectation of price increases) reach sustained levels over time.
For example, last week, Bloomberg quoted Federal Reserve Bank of Chicago President Charles Evans in “Fed’s Evans Says ‘Slow Progress’ in Economy Justifies Maintaining Stimulus“:
“Inflation is a continuing increase in the price level over time: A one-off increase in the price level is not inflation…Price increases have to be sustained.”
I duly noted that at no time does someone from the Federal Reserve insist that deflation is a continuing decrease in the price level over time!
Evans goes on to express his comfort with the current levels of inflation by citing empirical research showing no correlation between higher oil prices and inflation. Even a casual examination of the current record of price increases demonstrates that oil’s price rise is just one small part of the general increase in prices percolating in the economy, especially where demand is strong and supply is compromised. Regardless, the conclusion of this research is intuitive given the numerous supply-related fluctuations in oil that have occurred with and without Fed monetary action. As we saw above, it is not likely that the increase in prices in any one part of the economy will produce the sustained increase in price levels required to signal inflation’s arrival. Without an increase in the money supply, increases in oil prices steal money from some other products in the consumer’s basket of goods. The net impact on official inflation statistics may be close to zero and “core” inflation, subtracting energy and food, could even decrease! But if increases in the money supply happen to coincide with a strengthening oil market, I contend we better look out.
The bias of the Federal Reserve toward inflation is also rooted in the concept that “a little inflation” is good for the economy because it encourages spending. Specifically, inflation encourages consumers to buy today to avoid paying higher costs tomorrow. In a deflationary environment, consumers just wait and wait and wait. Boudreaux and Roberts sharply criticize this theory and cite examples demonstrating the fallacy of such thinking. For example, with even a little inflation, why don’t sellers just wait until tomorrow to sell since they can make higher profits? Why do consumers buy computers and many other electronic goods knowing full well that prices will be lower tomorrow (not to mention these goods will be of higher quality)? Why was America’s post-Civil War economy so strong for almost 30 years despite persistent deflation? Clearly, buyers and sellers are motivated not just by relative prices, but also the relative value (or utility) gained from consumption and/or alternative investments.
I have covered the core concepts reviewed by Boudreaux and Roberts related to the philosophy and approach of “Inflation Watch.” If you want more detail, I highly recommend listening to the podcast, reviewing the transcript, and/or perusing some of the references provided by EconTalk. Hopefully, you have also gained a better understanding of Inflation Watch’s mission: “Watching for inflation here, there and everywhere.”
It is pretty amazing that China has experienced rapid growth without rate hikes for electricity, but such has been the case for two years. The resulting power shortages are getting dire according to “China Raises Power Prices as Shortages Loom“:
“China’s electricity demand is running so far ahead of supply that it is expected to be short of 30-40 gigawatts of power capacity this summer, twice the deficit caused in Japan by the earthquake and tsunami on March 11.”
China is hiking rates by 3% for some users in an apparent effort to cool demand and/or encourage the production of more supply. It is feared that increases in supply will only further drive up the price of coal and offset any profits power companies would have otherwise earned.
In “Back in the green: CEO pay jumps 13 per cent“, Globe and Mail reports that CEOs at Canada’s top 100 public companies received average pay raises of 13% in 2010. This comes on the heels of dismal pay performance in 2009 and 2010 where pay was essentially flat. 2010’s pay hikes is similar to the double-digit pay gains Canada’s CEO typically experienced before the recession.
The article includes an interesting discussion of “performance share units” which calibrates performance-based pay to the company’s relative performance to its peers. This method prevents pay hikes from general market forces that the CEO does not control, like the rising price of oil.
Ford (F) raised its average car price for a third time this year. The latest increase is extremely small, just $124. For all of 2011, CNCB reports that Ford has increased prices a total of 1.3%, or $375.
Ford is clearly reluctant to hike prices and is choosing to dribble them in the hopes they go essentially unnoticed by the average consumer.
Ford cited higher commodity prices for this latest increase.
It had to happen eventually…Japan’s core CPI finally experienced some year-over-year lift. In “Japan Core CPI Rises First Time Since 2008“, Reuters reports:
“Japan’s core consumer prices rose in April from a year earlier for the first time in more than two years as the impact of school tuition fees faded and commodity costs crept up, but underlying prices remained weak as the March earthquake hurt consumption…
…A government policy to subsidize school tuition fees is no longer distorting annual changes in prices, as more than a year has passed since the policy was introduced. The move was estimated to have pushed down overall prices by about 0.5 percent.”
OK. So this lift is not likely to last given the special adjustment, but it is a nice break from the regular drone of deflationary news. As I have stated before, I tend not to pay much attention to official government statistics on inflation, but this headline alone made me pause. The rest of the article summarizes the prospects for Japan’s post-disaster recovery economy.
J.M. Smucker (SJM) announced today that “sustained increases in green coffee costs” have forced the company to hike prices on many of its coffee brands:
“The J. M. Smucker Company…announced today that it increased the list price for the majority of its coffee products sold in the United States, primarily consisting of items sold under the Folgers®, Dunkin’ Donuts®, Millstone®, and Folgers® Gourmet Selections® brand names. Prices will increase an average of 11 percent on impacted items.”
This price hike motivated AP to run a story summarizing the state of the coffee industry and market and the experiences with soaring costs – see “Coffee drinkers keep chugging, as prices rise“. AP notes that SJM has increased coffee prices four times in the past year. SJM’s stock performance suggests this pricing power has contributed to a strong bottom line.
The pricers at AK Steel (AKS) are at it again. This time, the company announced price hikes for carbon steel products:
“Base prices will increase by $50 per ton for hot rolled and cold rolled carbon steel products, and by $60 per ton for coated carbon steel products.”
AKS is facing higher input costs for making steel. More importantly, the company is experiencing stronger demand for its carbon steel products.
Disclosure: author owns shares in AKS
As early as July, 2009, we cautioned readers that a crash in used car prices was nowhere on the horizon. Today, we get news that not only has a crash NOT occurred, but instead used car prices have jumped to 16-year highs. From the Toledo Blade:
“Prices of previously owned vehicles began increasing in March as a reaction to slowed new-car production by Japanese automakers hurt by natural disasters in the island nation. But the rise has been exacerbated by soaring gas prices and a used-vehicle shortage.”
From the Detroit Free Press:
“People are holding on to cars and trucks for about a year longer than they did before the recession, which has created a tight supply of used vehicles. So few are on the market that prices have risen to their highest in at least 16 years.
Dealers are paying an average of $11,660 for a used car or truck, up almost 30 percent since December 2008.”
Click here for archives on pricing in the auto industry.
In “Homes: Chinese Buyers Make Vancouver Pricier Than NYC“, Bloomberg provides a startling and illuminating account of the dynamics in Vancouver’s over-heated real estate market. The statistics are absolutely astounding. Here is a sample:
“Sales of detached homes, townhouses and condominiums in metropolitan Vancouver jumped 70 percent in February from January, to 3,097 units from 1,819, and were up 25 percent from a year earlier, according to the Real Estate Board of Greater Vancouver. In March, sales climbed 32 percent from February, to just shy of a record for the month of 4,371 transactions set in 2004. Sales increased by 80 percent from two years ago.”
“In 2010, Vancouver had the third-highest housing costs among English-speaking cities worldwide, according to Canada’s Frontier Centre for Public Policy. Only Hong Kong and Sydney, another magnet of Asian immigration, were more expensive. Vancouver’s median home price of C$602,000 ($618,000) was 9.5 times the annual median household income of C$63,100, the group said in a study released Jan. 24. Canada had a 4.6 national multiple, making it ‘seriously unaffordable,’ while the U.S. at 3.3 was ‘moderately unaffordable,’ the study showed. To be affordable, the multiple must be 3 or less.”
The rest of the article explains how buyers from China are helping to drive prices in Vancouver as they escape property restrictions back home. Given three waves of Chinese buyers have descended upon Vancouver since 1990, market participants must feel like everything is normal. As an outsider, this market seems to have all the classic markers of a bubble. As long as the money keeps flowing, the market will remain inflated…
Even fast food restaurants have determined that the market can accept some price hikes. In its latest earnings report, Wendy’s/Arby’s Group (WEN) provided an outlook that includes plans to implement “prudent” and “strategic” price increases to at least partially offset rising commodity prices, especially in beef (emphasis mine):
“We expect to generate strong sales growth at Wendy’s for the remainder of the year driven by exciting new product introductions, including hamburgers, chicken and salads, in addition to strategic price increases…Margins will be negatively impacted by increases in commodity costs primarily driven by unprecedented beef prices that are affecting the restaurant industry. We have reaffirmed our same-store sales outlook and expect to offset some of these commodity increases with prudent price increases, while protecting transactions and market share…”
WEN expects improved sales trends through the rest of the year, and this must help give them the confidence to raise prices.
The company’s confidence really shines through as management discusses future prospects further in light of higher commodity costs:
“Although we have revised our outlook for the year to reflect higher expected commodity costs, we continue to make significant strategic progress improving our core menu offerings including breakfast. We are also pleased with our progress developing Wendy’s international business, which represents a significant opportunity. The Arby’s turnaround is progressing nicely and we plan to resume our stock buyback program after the conclusion of the strategic alternatives process, subject to market conditions. As we’ve said before, 2011 is a transition year and we are confident that the investments we are making will position Wendy’s for 10% to 15% average annual EBITDA growth in 2012 and beyond…”
Disclosure: author owns WEN
Dean Foods (DF) is yet one more company demonstrating confidence in its ability to wield pricing power. DF reported earnings Tuesday that showed weak pricing in milk but a strong focus in raising prices to battle rising input costs (emphasis mine):
“…First, we have stepped up our agenda to reduce costs and improve profitability. Second, because input cost volatility is here to stay, we are focused on pricing to offset inflation through efficient pricing mechanisms. We are working hard to maintain, and where necessary, improve our pricing tools…”
I liked how the earnings announcement avoided direct mention of raising the prices of non-milk products.
The market liked the announcement too. The stock soared 11.5% on the day.
Nightly Business Report produced a short video segment describing China’s inflation woes (transcript included) called “China’s Inflation Battle.” The commentator identifies China’s RMB¥ 4 trillion stimulus program (about $585B USD at the time) as the original source of the inflation and takes us to Pengshui, 1000 miles from Beijing, to see some of the examples of how inflation is impacting the lives of the average Chinese person.
The most interesting quote came from Associate Professor Patrick Chovanec of Tsinghua University, School of Economics and Management:
“When you see over 50 percent growth in the money supply, the question isn’t, why is there inflation? The question is, why isn’t there more inflation? Why haven’t we seen it sooner? The reason is because a lot of that money didn’t go into a consumption boom. It went into an investment boom.”
It is a scary thought to think inflation problems could (will?) get even worse once the Chinese figure out how to make use of all this massive investment.
Allstate is raising homeowner’s insurance premiums 23% when policyholders renew. This is half the increase Allstate sought for approval from Georgia regulators.
Allstate blames “record-level storm events over the past few years” and notes that rates in Georgia will now be comparable to rates throughout the Southeast.
For more details see AJC: “Years of storms bring higher insurance rates“
America’s CEOs have been rewarded for performance that has driven corporate profits to record levels.
“The typical pay package for the head of a company in the Standard & Poor’s 500 was $9 million in 2010, according to an analysis by The Associated Press using data provided by Equilar, an executive compensation research firm. That was 24 percent higher than a year earlier, reversing two years of declines.”
“Executives were showered with more pay of all types — salaries, bonuses, stock, options and perks. The biggest gains came in cash bonuses: Two-thirds of executives got a bigger one than they had in 2009, some more than three times as big.”
This situation presents an odd dichotomy. The housing market remains moribund and likely double-dipped, the unemployment rate and jobless situation has shown little improvement in many, many months. Yet, corporate profits and CEO pay could not be better. Even as the Federal Reserve seeks to keep monetary policy loose and accomodative, I suspect the current momentum will continue as companies continue to make hay with what they’ve got: more jobless profits…
As is said when the Fed prints money, it has to go somewhere. We have found one more resting spot for that fresh cash!
CNBC reported on a study from Clear Capital titled “Clear Capital Reports national Double Dip“:
“Home prices have double dipped nationwide, now lower than their March 2009 trough…a surge in sales of foreclosed properties and a big push by banks to facilitate short sales…[forced] home prices down dramatically. Sales of bank-owned (REO) properties hit 34.5 percent of the market, according to the survey, resulting in a national price drop of 4.9 percent quarterly and 5 percent year-over-year. National home prices have fallen 11.5 percent in the past nine months, a rate not seen since 2008.”
CNBC goes on to indicate that the foreclosure problem has spread beyond just the “bubble” markets that were at the center of the housing crisis:
“…the mid-west is seeing a surge in REOs now, thanks to the plain old recession. 40 percent of the Chicago market is foreclosures, 43 percent in Cleveland and 51 percent in Minneapolis. Home prices fell 8.7 percent in the Mid-West during the past three months compared to the previous quarter.”
It is once again important to note that housing was one of the big targets of the Federal Reserve’s dollar-printing campaign. Given that housing prices have not responded while commodity prices have soared, we must now wonder whether the Fed believes it simply did not print enough, whether there is a longer time lag than anticipated to seeing an impact in housing, and/or worry about the unintended consequences that have yet to be seen. The money had to go somewhere; so far, it has not been into housing.
Peet’s Cofee (PEET) reported earnings results this evening. The company reaffirmed revenue targets for the year but lowered earnings guidance because of the rising cost of coffee (emphasis mine):
“Reaffirms full-year total net revenue growth in the 8% to 10% range. Lowers full-year diluted earnings per share guidance by $0.10 to the $1.43 to $1.50 range, driven entirely by the significant rise in coffee costs during the last three months“
Interestingly enough, PEET implied that the run-up in coffee prices is overdone. This news should provide some reassurance and relief to coffee fans, especially since it seems PEET is resisting the urge to ramp up its own prices to keep up with the rising input costs (emphasis mine):
“While we expect to offset most of the year-over-year coffee cost increase we’re experiencing, we will continue to act in the long-term best interests of our business and not overreact to the recent run-up in world coffee prices.”
Pilgrim’s Price (PPC) is the second-largest chicken producer in the world. It emerged from bankruptcy at the end of 2009 just as the economy was finally recovering from the recession. Over a year later, the company continues to struggle, especially with soaring costs for feed and energy.
PPC disappointed the market with its first quarter financial performance. The report contained some important information on market prices and industry cost pressures as well as the prospect for higher prices in the future. Key quotes below (emphasis mine):
“Market prices for breast meat averaged $1.26 per pound, down 10% from a year ago, while market prices for wings fell 38%, to $1.00 per pound.”
“Export demand remained very strong during the quarter, with volume rising 90% to an all-time record for the period and sales increasing by a similar amount. The company attributed export gains to the lower value of the dollar as well as chicken’s value proposition versus higher-priced beef and pork in international markets.”
“…the company has recently succeeded in negotiating additional price increases with some of its retail and foodservice customers in response to continued increases in feed costs.”
“Despite now having covered nearly all of our anticipated grain needs through the end of 2011, we are facing at least $500 million in higher feed costs this year. Our customers recognize that the unrelenting upward march of corn and soybean meal is placing extreme pressure on chicken producers and that there must be some sharing of the cost burden in order to ensure a viable business model. To achieve that, we will continue to look at further price increases and will execute structural changes in our book of business with regard to fixed versus market-based pricing…”
Note: PPC declined 9.5% in response to the first quarter’s earnings results.