What Would It Take to Ignite Inflation?

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We see a few signs of budding inflation.  But will it bloom? Survey data point to businesses’ higher costs in recent months.  The key question is whether those cost increases are temporary or persistent, and whether they will be passed on to their customers in higher prices.  That, in turn, depends on the cause.

Let’s take a closer look. We do see signs of increasing cost pressures in both the goods and the services sectors, in data from the Institute for Supply Management.

ISM Surveys

Manufacturers reported paying higher prices recently, and the trend is moving up a bit.  The ISM-Manufacturing Prices Index registered 58 in September, which is an increase of 4 points compared to August, and follows a 14.5 point increase in August compared to July.  In June, it printed 37.0.  Readings above “50” indicates more businesses than fewer are reporting higher input costs. In September, 27% of respondents reported paying higher prices, 11% reported paying lower prices, and 62% of supply executives reported paying the same prices as in August.

They seem to be passing along some of those price increases to their customers.  The ISM-Non Manufacturing Survey, which includes retailers and wholesalers, among other services industries, shows even more cost pressures.  ISM’s Non-Manufacturing Prices Index for September registered 68.1, an increase of 3.8 points from the 64.3 percent reported in August. It is considerably higher than the 48.9 in June.  In September, 28% of respondents reported paying higher prices, 71% indicated no change in prices paid is 71%, and 1% of the respondents reported lower prices.

How Would Business React to Inflation?

If these price increases are seen as persistent, rather than transitory, will they pass on those higher costs to their customers?  Here’s what the Atlanta Fed recently reported on a study of firms that were presented with a hypothetical increase in their costs by either 2% or 6%, with the goal of finding out pricing power and cost pass-through to the end customer:

On average, firms faced with the 2 percent cost increase were likely to pass about 1.3 percentage points (or 66 percent) to their customers. In the portion of our panel considering the 6 percent cost increase, the average impact on customer prices was 3.8 percentage points (or about 63 percent of the cost increase). So in the aggregate, firms think they can pass about two-thirds of any cost increase through to prices, and that belief holds roughly true whether the cost increase is relatively modest or somewhat large.

So, we see that businesses are reporting that their costs are going up, and that they believe they can pass along much of those cost increases. (The difference, of course, would be reflected in reduced profit margins.)  How do businesses see these costs, as something to pass along – which can hurt sales, if customers switch to a competitor – or to absorb perhaps temporary cost increases to maintain market share? The answer is what is perceived as the cause, and how long that condition is perceived to last.

Is the Fed Blowing a Bubble?

What many observers might blame, rightly or wrongly, are the actions of the Fed.  In the minds of many observers is the monetarist view of inflation, and some may say something to the effect of, “All that money the Fed is ‘printing’ will cause prices to rise.  Inflation is a monetary phenomenon.”  Many people equate QE with an expansionary monetary policy.  But is that really true with the Fed’s quantitative easing programs?  Or, are other factors instead more of a concern?

Let’s put to rest that notion that QE directly causes inflation.  As many investors, if not the general public, recognize, the Fed’s asset purchases aren’t intended to expand money in circulation, but instead to bring down longer term interest rates through longer duration bond purchases.  (M2 money supply has grown 6.3% in the year to August, mostly in the form of savings deposits.)

Here’s what happens when the Fed buys financial assets, whether they be Treasury bonds or mortgage instruments.  The party, perhaps an institutional investor or a financial institution, that receives the cash from the Fed then takes those proceeds and buys another investment security.  Some of those funds could be used for new loans, if both borrower and lender alike are willing and able to transact.

Unless it is lent out, where is the cash? It is held all along in the banking system, parked right back at the Federal Reserve, in the form of banks’ “excess reserves,” where it currently earns 0.25% interest.  Those monies were never “printed,” because they haven’t left the financial system.

The only way those funds can become inflationary is if they leave banks’ excess reserves.  One way might be if perhaps a person sells a security to the Fed, receives the cash and buys, say, a car. However, there is little reason to think people are buying toasters with funds they receive by selling bonds to the Fed.  The savings rate is still positive, meaning the Fed’s purchases are not being used by consumers for shopping sprees as consumers are still adding financial assets to their balance sheets, not selling them.

Instead, the biggest way those funds can become inflationary is if banks start making substantial new loans from those excess reserves.  Right now, we see that data from the FDIC shows that loan growth in the 12 months through June was 2.7%, aggregated among all bank loan types.  Over the past two years, loan growth totaled just 1.6% – and that is not an annualized figure.  Aggregate loan growth so far is tepid, especially compared to nominal GDP growth, which was 3.9% year-over-year to the second quarter 2012. (Loan data are not adjusted for inflation, hence the use of nominal GDP.)

A Lot of Slack

With income growth stagnant and many people not quite creditworthy, banks might not find many suitable customers.  That may keep supply of credit low, at the same time demand to borrow funds is similarly restrained.

Consumers are more focused on paying down debt than they are in taking out more loans, except for two categories: auto and student loans.  Consumers have been buying more cars, most likely because the average age of cars on the road is at a record high.  Unemployed workers may take out student loans to upgrade their skills to find a job.  Combined, the category of non-revolving loans that includes this debt rose by 5% so far in 2012 and is up 22% from 2008.

However, credit card debt hasn’t grown by much since the end of 2011, and is 17% less than its 2008 peak.  Outside of cars, banks don’t appear to be granting loans to fuel consumer spending, especially for unsecured credit products.  Thus, unless both banks and consumers change their view of consumer debt, spending gains here will need to come primarily from income or savings.  See Steve Hansen’s report today for the latest consumer credit data.

Businesses aren’t borrowing as much, either. Big corporations have a treasure trove of just over a trillion dollars in cash, and hardly need to borrow.  (And I might also add this might keep supply of new corporate bonds less than what it would be otherwise.)

Meanwhile, the National Federation of Independent Businesses reports more than half of small businesses explicitly stated in the group’s survey that they do not want a new loan.  Thus, even if banks were willing to lend, their potential customers are not enthused to borrow.  So those funds in excess reserves are lying fallow.

But Eventually Won’t the ‘Extra’ Money Be Spent?

Perhaps at some point those reserves might get lent.  However, should the economy show signs of any inflationary pressures, the Fed can take action to reduce the economy’s inflationary potential.  Besides actually selling bonds in the open market or hiking the Fed Funds rate, the Fed can simply, and quite easily, increase the interest rate it pays on those excess reserves. This reduces the incentive for a bank to lend funds to Sally to buy a car when it can earn risk-free interest from the Federal Reserve.

That said, investors can take the proceeds from selling bonds to the Fed and invest them into other assets, like stocks or commodities.  In that vein, we must consider the extent to which QE could trigger commodity price spikes. That is a concern, but recently, however, commodity prices have been coming down.  Additionally, commodities and basic material inputs tend to be a small component of the final price of a good or service.

Exchange Rates May Actually Favor the Dollar

An intervening factor is currencies.  A stronger dollar compared the euro from weakness in Europe would tend to keep commodity prices lower, as many commodities are priced in dollars.  A stronger dollar(vs. what it would be otherwise) means more expensive oil in Europe, all things equal, and that means relatively lower commodity prices as global traders tend not to bid up prices as much.  Overall, the U.S. dollar index against a basket of currencies is little changed from a year ago, though has bounced around a bit in between.

And a stronger dollar relative to what it would be otherwise can keep inflation in the U.S. under control by making imported goods cheaper.  So far, quantitative easing hasn’t prompted the amount of dollar weakness that some had forecast, again, because it is not intended to increase money supply.  That means inflation from imports is tame, decreasing 2.2% over the past year.  Of course, when the Fed is a ready buyer of bonds, it may give foreign investors greater confidence to maintain their own purchases.

Inflation Expectations

Considering all of these factors, consumers, businesses and investors aren’t expecting increases in certain inputs or commodity prices (gas, food, etc.) to be long lasting.  These prices have a way of bouncing around that don’t always affect expectations over the long run, say more than five years or so.  And indeed, inflation expectations have been contained.  Expectations have probably been influenced by the inflation experienced in the past couple of years with CPI fluctuating above and below 2.5% and PPI declining sharply from above 7% to approaching 0% for finished goods and actually deflating in 2012 for crude materials after inflating at double digit rates in 2011.

In the Consumer Confidence Survey from The Conference Board, consumers’ inflation expectations have remained stable, even dropping a bit to 3.3% from 3.6%, for the next 12 months.  Investors’ inflation expectations, per the TIPS breakeven rates, are also stable, have been in the range of about 2.2% to 2.4%, though they spiked higher (and then retreated) immediately following the announcement of QE3.  The Atlanta Fed reports that businesses have expected inflation to be between 1.5% and 2.0% in a remarkably stable range over the past year.

… Can Be Self-Fulfilling Prophecies

Inflation expectations often tend to lead actual inflation, as the expectation of higher prices tends to be a self-fulfilling prophecy. Quite simply, people are more willing to pay higher prices when they expect them to be as such.  Workers are more likely to demand higher wages when they expect their expenses to climb. Wages are a bit different from other cost inputs for a company, however.

In contrast to commodity prices, wages tend to make up around two-thirds of the cost of goods and services, economy-wide.  And also unlike commodity prices, which can rise and fall on a daily basis, wages are sticky.  Companies cannot change workers’ salaries the same way the crude oil trades in the commodities pits.  Thus, employers will think twice about granting pay raises, and for the time being, companies in most (though not all) industries are able to avoid doling out more money to their staff.

Economic Slack is Everywhere

High unemployment means more competition for jobs and smaller pay raises, and this limits companies’ cost components.  Fewer pay raises means less demand for goods and services, and this means less ability to pass along higher prices. Low wage growth, for both the cost and revenue side of companies’ income statements, argues for continued lower inflation and interest rates.

Thus, this thesis of resource slack is one of the competing theories for whether inflation will become problem.  Monitoring how much slack in the economy – particularly for labor – is perhaps key to determining when inflation from rising wages might take hold.

What do we see right now for resource slack?  The Atlanta Fed polled businesses and found that, on average, companies say their current sales are about 8% below what they say is a “normal” level.  However, business’ industry matters.  Sectors in services are seeing a different pattern than goods-producing sectors.

Retailers, for example, say their current sales are a little less than 2% below normal. And firms in the leisure/hospitality and the transportation/warehousing sectors say they are operating at, or just a shade above, normal levels.  Not coincidentally, job growth in these services sectors has been strong in recent months, outpacing overall job growth.  In food services alone, the job growth rate has been double total job growth since the end of 2009.  Wage increases could occur in these often low-wage, labor intensive industries.

On the other hand, durable goods manufacturers report that their current sales levels are nearly 12% below normal, and finance and insurance companies say their sales are almost 17% below normal.  Housing is a long ways off – construction firms are 28% under capacity according to the Atlanta Fed’s survey.  Thus, even if the Fed’s moves to lower rates triggers more housing construction, there is scant pressure to grant wide-scale pay increases there.  Some manufacturing companies, though, report some difficulty in finding talent with the right technical backgrounds, so certain occupations may see rising wages here.

Without rising incomes, whether or not companies believe that they can increase prices acting individually, consumer spending cannot support spending in volume terms at current levels if all companies increase prices, in aggregate.  Thus, there is a limit to pricing power when one views the economy as a whole instead of individual companies.

That said, more consumers are expecting their incomes to increase.  The proportion of those expecting that outcome rose to 16.3% in the latest Consumer Confidence Survey from The Conference Board, up from 16.0% last month, reaching the highest level of the year.

However, until and unless pay raises actually become a reality – and that might be less likely until the supply of labor is more balanced with the demand – then it is hard to expect substantial inflation.  Consumers’ response to rising prices will be to purchase fewer goods and services, which then begs the question of whether price increases would stick.

In the meantime, since inflation expectations are generally stable and low, the Fed to continue its easy money policies.  Should those expectations increase, the Fed can moderate its stance before those expectations become reality.  I believe that slack in the economy is the driving force keeping inflation suppressed, while QE is not, in itself, inflationary.

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About the Author

Gene Balas has over twenty years’ experience in financial and economic analysis. He is the Chief Investment Strategist for East End Wealth Management, evaluating economic conditions and other variables to develop investment strategy. He also writes economic commentary for TheStreet’s RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop investment strategy. He also headed the firm’s investment manager due diligence efforts. Prior to GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in 1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.