November 24, 2004
How benign is inflation and what, beside oil, is
causing the recent rise in prices?
This question certainly is being asked at the Federal
Reserve now that the Producers’ Price Index (PPI) for October jumped 1.7
percent and consumer prices(CPI) advanced a sharp 0.6 percent.
When the direct impact of food and energy are
eliminated, the gains were 0.3 percent for all other finished goods in the
PPI and 0.2 percent for consumer prices.
Thus, food and energy were major forces in pushing up prices.
The spurt in food was largely contained to fruits and
seriously impaired the production of citrus fruits and vegetables,
especially winter tomatoes. Until
next April, when most of the east coast will be growing tomatoes, tomato
production is limited to Florida, parts of the Rio Grande and California
(with some Arizona production). Almost
the entire Florida crop was destroyed, so tomato prices are soaring.
Certainly, the food price spurt must be temporary and
should appropriately be discounted. But
what about energy?
Oil prices have been surging for most of the year.
Some economists actually believe that some of the core inflation is
beginning to reflect the higher energy costs embedded in production and
distribution costs. Until oil
prices fall below their average for the year (about $43 per barrel) further
acceleration of those prices should be expected.
Will oil prices fall?
Fuel oil inventories are unusually low this time of
year. However, previous
concerns of low inventories of crude petroleum have dissipated after eight
consecutive weeks of rising crude inventories.
Also, natural gas in storage is the highest since those records began
in 1994. While a serious cold
snap in the next few weeks certainly could raise questions of adequacy,
there is no evidence that such a freeze is developing.
For example, unseasonably cold weather in Barrow,
Alaska earlier this month has been replaced by more normal temperatures.
Fairbanks, Alaska actually is unseasonably warm.
The wooly warm has a fat tail (a sign of cold ahead) but the northern
jet stream remains above our borders. Weather
can always surprise, but I would not bet on a cold winter at this point.
OPEC nations indicated that they would raise capacity
by nearly 6 percent in 2005. Russia
says another 5 percent capacity gain could be expected there.
If these claims materialize, oil capacity will increase almost 3
million barrels per day next year. Unless
we have even more production disruptions than the hurricane damage to Gulf
of Mexico production, Nigerian unrest, a Norwegian strike, and the
insurgency attacks on Iraq production, that capacity gain will outstrip any
reasonable estimates of growing oil demand.
Again, nothing is guaranteed, but I would be more
surprised if oil prices were above $35 per barrel next spring than if they
were below that level. Using my
$43 rule, oil prices no longer would have any indirect impact upon
So, if food and oil really will only have short term
impacts upon inflation, does that mean no sustainable gains in inflation are
I will not explore labor costs at this time except to
indicate that accelerating hourly wages are being offset by slowing hourly
benefit costs. As I mentioned
last week, productivity gains probably are slowing but should remain
sufficiently high to minimize the impact of labor costs upon price
Unfortunately, one additional source of inflation must
be considered: the weakening
dollar. About 15 percent of our
goods and services are imported. If
the dollar falls in value against other currencies, those imports either
rise in price or the producers accept reduced profits.
Apparently, the dollar has fallen sufficiently to make further profit
Some of the increased prices in the PPI were for
machinery, much of which is imported. Even
the price declines for computers began to slow.
Furthermore, the crude materials other than food and energy increased
sharply for the third time in the past four months. Some of these gains reflect higher material prices, which
depend more upon world than domestic price pressures.
Certainly, that 4.4 percent gain in the PPI over the
past twelve months and the 3.2 percent gain for consumer prices should not
be used for next year’s projections.
However, the core inflation rate, now at 2 percent and slowly rising,
probably will continue upward through much of next year.
If the Federal Reserve also reaches this conclusion, they probably will not stop raising short term interest rate targets until the federal funds rate reaches 3.5 to 4 percent. Bond investors clearly do not expect that to happen; but they have been wrong in the recent past.