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 vegetables.  Hurricanes 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For example, unseasonably cold weather in Barrow, Alaska earlier this month has been replaced by more normal temperatures.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 inflation. 

So, if food and oil really will only have short term impacts upon inflation, does that mean no sustainable gains in inflation are likely?

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 pressures. 

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 reductions unacceptable. 

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. 

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