Gavyn Davies at the Financial Times writes a good review and critique of William Dudley’s recent speech at New York University’s Stern School of Business, New York City titled “Prospects for the Economy and Monetary Policy.”
Davies notes that Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, remains laser focused on the output gap and unemployment in the U.S. and relies on them to provide a buffer of comfort versus inflation. Dudley is not worried about other signals of inflationary pressures, like rising commodity prices driven by demand, as long as inflation expectations remain contained. We have shown numerous examples in these pages of how these expectations are actually tilting toward inflation. It remains unclear when the Federal Reserve will also notice.
For more details see “The Fed doves have not caved in.”
A contraction in credit has served as a firm pillar of support for those who still fear deflation is the biggest threat to the U.S. economy. It seems even that pillar is slowly but surely weakening. In “Behind a Rise in Auto Sales, Easier Credit“, the New York Times reveals that loosening credit standards and increased lending have helped boost auto sales over the past year. Michael E. Maroone, the president of AutoNation, is cited as claiming that increased credit was the most important driver of auto sales last year. The statistics from this detailed article are a vivid reminder of how fast consumer borrowing can recover under the right conditions.
Consider these statistics quoted from the article:
- Sales of new cars rose 11 percent, to around 11.4 million, in 2010 and are off to an even stronger start this year.
- More than 859,000 new cars were sold to consumers with a so-called subprime credit rating in 2010, a nearly 60 percent increase from the year before.
- [The packaged consumer loan] market stood at $36 billion in 2008, during the throes of the crisis, but by 2010 it had bounced back to almost $58 billion. Bankers and analysts project that could rise by as much as 15 percent in 2011.
- Over all, lending to subprime borrowers has risen to about 38 percent of the auto finance market, although it is still well below its precrisis highs when it made up nearly half of all loans.
As the NYTimes notes, “…the gradual expansion of credit in virtually every area except real estate is an important sign that the American economy is returning to health.” So while an obsession with housing statistics can mire one in deflationary blues, so many other corners of the economy are flashing much different signals.
CNBC’s Lori Ann LaRocco interviewed Diane Swonk, Chief Economist at Mesirow Financial, about the status of the economy.
Swonk noted that most of her clients are worried about inflation. However, she sees inflation as a two-sided coin. On one side, inflation is squeezing producers, but companies that deal with consumers cannot pass on price increases:
“I remind [my clients] of how little pass through inflation that we have experienced in the last decade.
When I ask them how much they have passed along to consumers and you see a fairly substantial break. There are those who can pass along some of the increase in costs if their clients are other businesses. Those who deal with consumers can’t pass along the increases as easily or are paying the price in volume if they do.”
Swonk also notes that rising oil prices will be destructive for all economies. In particular, higher oil prices will further increase food prices and magnify the suffering of poorer nations, leading to yet more social unrest.
Corporate profit margins have hit record levels, but it seems inflationary pressures are waiting in the wings to send those margins back toward the mean. Zero Hedge summarizes the latest Philly Fed report, pointing out that prices paid less prices received has not been higher since 1979.
- businesses try to increase prices, can’t, and see their margins cut;
- businesses do raise prices, people buy less, and revenue gets hit.
The stubbornly high unemployment rate has convinced many that resistance to price increases is a foregone conclusion. However, I would like to layer on a more nuanced scenario here. Given that increasing employment is the Federal Reserve’s stated goal of its latest quantitative easing program, we should assume that the Fed’s response to either of the above scenarios will be more quantitative easing. If profits or revenues fall, companies will not hire more workers in response. If anything, companies will fire more workers. In other words, even with inflationary pressures building in the economy, especially in scenario #2, the Federal Reserve could actually find more reason to continue adding to those pressures. We may not get a self-reinforcing negative feedback loop, but it will feel close!
The Bank of England already faces this conundrum of accomodative monetary policies even in the face of stubbornly high inflation – but governor Mervyn King has found a lot of comfort in the United Kingdom’s current output gap and a conveniently tame outlook for inflation.
So, what if quantitative easing actually works and increases employment? Well, there should be a lot of increased prices waiting to eat into those newly minted paychecks.
It seems everywhere we look, inflationary pressures are inescapable. Corporate margins may be the last canary in the coal mine…
Looks like Singapore is now feeling some inflation pressure. The small island nation raised its inflation forecast for 2011 and may be forced to raise interest rates.
Bloomberg reports in “Singapore Raises 2011 Inflation Forecast to 3%-4% After Record Expansion“:
“Consumer prices may climb as much as 4 percent this year while exports may rise 10 percent, the trade ministry said today. The economy expanded a revised 14.5 percent in 2010, with gross domestic product growing an annualized 3.9 percent in the three months to Dec. 31 from the previous quarter, it said.”
Bloomberg also quotes Ravi Menon, the permanent secretary at the trade ministry:
“The key macroeconomic challenge this year will not be growth but dealing with emerging cost pressures…At this juncture, we expect these pressures to be relatively contained although there may be some pockets of tightness that we should continue to be watchful for.”
Inflation may be scheduling an autumn arrival in the U.S. The New York Times reports in “Companies Raise Prices as Commodity Costs Jump” that businesses across the economy are chomping at the bit to raise prices soon:
“A package of Oscar Mayer cold cuts. A pair of Nine West boots. A Whirlpool washing machine.
By the fall, people will most likely be paying more for each of them, as rising prices hit most consumer goods, say retailers, food companies and manufacturers of consumer products…
…Many big companies, including Kraft, Polo Ralph Lauren and Hanes, say they cannot hold off any longer and must raise prices to protect some profits.”
While such talk has come later in the economic cycle than we expected, its arrival should be taken seriously. The NYT article quotes analysts who take the other side of the story, for example claiming that consumers will not pay the higher prices. However, with corporate profits at historic levels despite extremely high unemployment, we should not underestimate the inflationary pressures that could stick once companies feel compelled to finally pass on their higher costs to consumers.
In “How to Profit From Inflation: The Scourge of Rising Prices Hasn’t Hit Home Yet, but the Underlying Signs Point to Trouble Ahead. Here’s What You Should Do Now” the WSJ provides some advice on getting ahead of inflation. It makes a lot of sense to buy inflation protection when it is “cheap.” In other words, you should worry about inflation when no one else is worrying instead of when the protection is expensive and inflation is on everyone’s mind. We are currently at a kind of middle ground where inflationary pressures are rising almost everywhere EXCEPT the United States, but I believe the U.S. is just the last bastion of deflationary expectations…
Some key quotes from the article:
“…it is a much different situation overseas, particularly in the developing world. In South Korea, the CPI rose at a 4.1% clip in January from a year earlier, higher than the 3.8% estimate. In Brazil, analysts expect prices to rise 5.6% this year, exceeding the central-bank target of 4.5%. China, meanwhile, has been boosting interest rates and raising bank capital requirements to keep inflation, which rose to 4.6% in December, in check….
…Even some developed economies are seeing rising prices. Inflation in the U.K. surged to 3.7% in December, while the euro zone’s rate climbed to 2.4% in January, the fastest rise since 2008.”
“…Of course, the main inflation driver is usually wages—and that isn’t a factor in the U.S., where high unemployment has kept a lid on pay for three years.”
The WSJ advices selling bonds, especially long-dated Treasurys. Sell some TIPS, Treasury inflation-protected securities, because the trade is over-crowded. The WSJ is also lukewarm to negative on real estate, gold, and stocks. On the other hand, WSJ recommends buying money-market mutual funds that are only invested in short-term bonds, inflation-linked savings and bonds products, floating-rate funds, and some commodities through ETFs.
Clearly, since inflation is already raging globally in energy, materials, and agriculture, it is a little late to give more straightforward advice than the eclectic mix presented above. The best time to get ahead of inflation was when deflationary fears gripped the entire globe. Inflation Watch has attempted to be one of the few reminders that deflation will not be a permanent condition in the global, or even U.S., economy.
As always, the best strategy for you will depend upon your own risk tolerance and inflation expectations and your financial goals.
Disclosure: author is long GG and TIP.