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Inflation Risks Head Higher

Author: Roger M. Kubarych
November 24, 2004
Council on Foreign Relations

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After every FOMC meeting, the Fed’s monetary policy decision is published along with an explanation. At the latest meeting on November 10, the statement said that “inflation and longer-term inflation expectations remain well contained” and that underlying inflation is “expected to be relatively low.” This is only a minor departure from a year ago, when the Fed expressed concerns about disinflation and left the impression that inflation risks were negligible.

In reality, however, inflation has risen in 2004 by every measure, although less dramatically when measured by the index that the Fed has chosen to emphasize: the core personal consumption expenditure price index. Detailed information on this rather obscure index is not easy to get. By contrast, there are ample sources of detailed information about the more familiar inflation measures – the CPI, PPI, import-export price indexes, and the index of employee compensation.

Yet perhaps most important for discerning inflationary pressures are market-determined prices. Almost all of these various market price indicators suggest that the main inflation measures are underestimating true inflation. And the majority of them point to a risk of higher inflation next year, especially excluding volatile food and energy components. Here is a review of what the inflation environment looks like as 2004 draws to a close.

Housing prices

Home values are still escalating at a torrid pace. According to data released Tuesday, the average price of existing single-family homes in the United States increased by 9.9% over the twelve months ended October 2004. The median price increased a little less but by a still substantial 8.8%. Only a small fraction of this price advance is reflected in the consumer price index, however. The overall CPI went up by 3.4% per annum in August-October period and by 3.2% from October 2003. About a third of this inflation came from higher energy costs. The core CPI went up by about one percentage point less. Over 40% of the CPI is related to housing expenses. Most of that (a weight of 23.4% in the CPI) reflects an estimate of what is called “owners’ equivalent rent of primary residence.” That estimate is based on a relatively tiny sample of single-family homes that are actually rented. The government’s statisticians simply make the assumption that the homeowners pay themselves rents of an equivalent magnitude. Over the twelve months ended October 2004, this measurement of housing costs went up by a scant 2.3%. If an older methodology were still being used, the CPI would have increased by well over 5% in the past year.

Energy prices

The various price indexes give widely divergent measures of the impact of energy prices on inflation. According to the CPI, energy prices went up 15% in the twelve months ended October 2004. According to the PPI, finished and intermediate energy goods went up 17% over that same period. But crude energy prices went up 33%.

Underlying that increase in crude energy prices was a 70% increase in crude petroleum prices, an 18% increase in natural gas prices, but only an estimated 9% increase in coal prices. Households don’t buy coal directly, but they do buy electricity, and something like half of US electricity is produced in coal-burning generating plants. But according to market-based price statistics for November released by the Department of Energy, coal prices have gone up by anywhere from 50% to 100% over the past twelve months, depending on the particular type of coal and where it is mined.. To be sure, much of the coal is bought on long-term contracts at fixed prices. But as an indicator of likely future inflationary pressures, the persisting increase in coal prices, which rivals what has been happening in the market for crude petroleum, injects a worrisome element.

Import-export prices

Over the past twelve months, the import price index has gone up by 9.7%. The biggest factor, naturally, was higher petroleum prices. They went up by 68%. But non-petroleum import prices also increased at the fastest pace in several years, by 2.6% compared to only 0.8% in the period October 2002-2003. What’s different is that the dollar has depreciates against most major currencies, while non-oil commodity prices have been high because of more rapid global economic growth. The biggest gains in import prices have been concentrated in only a handful of categories: unfinished metals, up 41% over the past year; finished metals, up 14%; paper products, up 7%; and building materials, up 5%. By contrast, capital goods prices are down 1%, a reflection of falling prices for PCs and other high tech products. Imported autos are up 1.8%, while other consumer goods are up just 0.5%.

There are, however, huge geographic differences in import price behavior. Imports of manufactured goods from the European Union are up 5.7% over the past year, reflecting part of the continuing appreciation of the euro and the pound sterling. By comparison, prices of Japanese imports into the US are up only 1.7%. And the prices of imports from Asian newly industrialized countries, including China, are unchanged. It is not surprising that there has been a continued rise in the US trade deficit, since there has been little or no price incentive for American consumers and businesses to shift from imports to domestically produced goods.

As for US exports, non-agricultural export prices have gone up by 5.2% in the past twelve months. In the previous twelve-month period, they rose just 0.6%. This reflects not only the stronger global economy, but also greater pricing power associated with the decline in the value of the dollar. But it is hardly sufficient to make much of a dent in the US trade deficit.

As the US government shifts from a “strong dollar” policy to one that tolerates and sometimes even encourages a weaker dollar, it is almost certain that there will be greater pressures on foreign exporters to raise their prices significantly. At least transitionally, this will put upward pressure on the overall rate of inflation in the US.

Labor Compensation

The combination of higher wages and employer-paid benefits such as health insurance has led to a steady increase in the Employment Cost Index of just under 4% a year since the end of 2000. With the economic recovery leading to faster productivity growth, however, unit labor costs actually fell during 2002, 2003, and the first half of this year. But in the third quarter, for the first time since late 2001, unit labor costs actually rose, although only by 0.6%. The likelihood is that productivity growth will continue to moderate in the next year or two. US businesses will attempt to pass through all or most of these cost increases onto product prices, and with a lower dollar providing something of a pricing umbrella, they are going to be increasingly successful.

Services prices

The US is a service-based economy and has been for many years. So much of the increase in consumer prices normally reflects the rising costs of various services. But that has not been the case in the past year. In an extremely rare development, the prices of the entire services sector rose only 2.5%, as compared with 2.9% for commodities, excluding energy. We have already expressed some doubts about the validity of the way the price of housing services is calculated. The result does not square with observations of what is happening in actual housing markets. What about other services?

The cost of medical care has been outpacing over CPI inflation for many years. In the past twelve months, the price of medical services has risen by 5%. Another source of continuing inflationary pressure is education expenses. They are up even faster, 6.4% from a year ago. But there have been offsetting factors, as well. The price of communications services is down by 4.3% in the past year, and it has a weight that is only slightly less than the weight of medical services in the CPI. And the price of public transportation services is estimated to have fallen by 3% over the past year, mainly reflecting terrific competition in the airlines industry as bankrupt companies push down air fares to keep up volume.

Market Implications

The Fed’s official forecast for next year is for core consumer price inflation to hold at the average level of this year. Based on the recent behavior of leading inflation indicators, this appears unlikely. So far the bond markets have largely shown considerable complacency about the medium-term outlook for inflation. But there are powerful forces at work that will tend to lift the core rate of consumer inflation. And it is likely that some of the factors that have been holding down inflation will fade in importance.

A policy of fostering or at least accepting a weakening dollar is designed to help reduce the size of the trade and current-account deficits. To be effective, such a policy relies on increases in the prices of imports and eventually in the prices of domestic goods and services to stimulate shifts in purchasing decisions. It is a pro-inflation policy. Financial markets are disregarding the lessons of history in assuming that the policy will not work that way this time.

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