June 26, 2002
How can anyone think of inflation when capacity is being
used at only slightly more than 75 percent, unemployment remains two percentage
points above pre-recession lows, and the latest information on inflation showed
a 0.4 percentage point decline in producers' prices and no change in consumer
Before I left Georgia State University, I was working on a project to develop leading inflation indicators. The Federal Reserve needs a nine to twelve month advance warning to be effective in eliminating inflation problems that might arise.
While I was able to develop some indicators that anticipate inflation, they only are 3 to 6 months ahead of the event.This is far to short to be useful for Federal Reserve policy.
I still do not have indicators that can do the job 9 to 12 months ahead, although I think I know how to solve that problem. The indicators should be enhanced or modified based upon prevailing conditions.
In other words, if my indicators point to inflation, but unemployment is rising and capacity utilization is below levels where orders are beginning to be reduced, generally the current condition, then positive readings on the inflation index would mean much less than if unemployment is falling (or below some "normal" rate) and capacity is being used at levels that cause delivery delays.
I have not yet finalized this methodology to see if it will deliver the 9 to 12 month lead time needed for serious policy initiatives. However, talking through what currently prevails probably provides some insights into what will be happening to inflation, and profits, in the next year.
First, the conditions are not favorable for inflation. Although unemployment fell last month, this was because of strong gains in household employment estimates and weak activity in job seekers. The employment gains were not confirmed by jobs reports filed for the nonagricultural employment report.
Unemployment could have peaked. However, further increases in unemployment appear more likely under these conditions.
With unemployment rates above 5 percent, what I currently would consider to be "normal", this means that very little infaltion will be coming from the labor markets.
Furthermore, wage changes are confirming the absence of wage concerns by workers. In the past eighteen months. Hourly wages have slowed form 4.3 percent above previous year levels to only 3.2 percent gains in the latest report.
Capacity utilization is in a similar non-inflationary environment. At 75.5 percent of utilization, capacity remains more than 1.5 points below levels that lead to further reductions in investment. There have been some delivery delays, but the magnitude has not been great.
On the other hand, the utilization rates are rising. In economics, sometimes it is less interesting where you are than where you are going and how fast you are traveling. Even on those measures, utilization shows that the inflation threshhold has not been reached.
Therefore, the risk of serious inflation at this time remains small.
Nevertheless, several of my key inflation indicators are beginning to stir.
Crude material prices other than food and energy, (the scrap, wastepaper, sand, gravel, cotton fibers, etc) have increased sharply in three of the past four months, including the latest two. This is almost enough to indicate a trend.
The ratio of household employment to the adult population also is beginning to stir. This is one of the indicators used by Columbia University, the only school currently publishing leading inflation indicators. Unfortunately, sampling error could distort this statistic for several months.
Money growth also has reappeared. Currency, bank deposits, and money market deposits held by individuals have begun to grow sharply relative to the growth of inflation. If this trend persists, some inflationary fallout might occur.
Finally, the dollar has begun to lose value against other currencies. The value loss has been smaller in North American than elsewhere, but inflation certainly could occur if our international competitors need to charge more dollars to pay wages back home.
On the other hand, unit labor costs in manufacturing continue to plunge. I already talked about one component of those costs--hourly wages. The other is productivity. The 4 percent productivity gains during a recession are truly impressive. Goods do not need higher prices to make larger profits.
Excess inventories, another measure of inflationary prospects, is in balance after being excessive for more than a year. However, inventories again are becoming high in autos and clothing. We already are seeing price concessions for the latter and expect to see more aggressive sales initiatves soon for the former.
On balance, these indicators do not see inflation ahead. The most likely risk is slight accelerations in price pressures about a year from now. Certainly not enough to put the Federal Reserve on alert.
However, the indicators suggest strength in another variable, corporate profits. If deflation is easing and labor costs continue to plunge, then profits will be growing as long as sales are growing.
Furthermore profits will be increasing by a multiple amount of sales early in a recovery. Thus, growth in operating profits of 15-20 percent in the next eighteen months is highly likely. If inflation also surfaces, the gains will be more, but the Federal Reserve will need to raise finance costs to get prices under control.
In other words, my indicators see almost an ideal, if subdued, environment for imrpoved corporate profitability. All I need now is for the stock market to agree.