Inflation Detectives Are Rounding Up The Wrong Suspects

If commodity prices are on the upswing, can inflation be far behind? That's one of the key questions bugging the financial markets and America's Federal Reserve these days. So far this year, the Commodity Research Bureau's spot price index of industrial raw materials has risen a hefty 12.7%. And the Journal of Commerce's more inclusive index of 18 industrial commodities is up nearly 11%.

Since most commodities are internationally traded, many U.S. investors have been quick to interpret the commodity-price surge as a sign that global demand pressures are building fast. With recoveries overseas reinforcing the impact of the maturing U.S. expansion, they fear that costlier raw materials will soon affect final product prices and fan inflationary fires.

While economist L. Douglas Lee of NatWest Securities Corp. also detects growing inflationary risks, he claims that rising commodity prices are the wrong culprit. Output in other industrial nations is still severely depressed, he notes, and highly volatile materials prices often give false signals of impending inflation.

More important, Lee points out that currency shifts have distorted the significance of commodity-price changes. Although the cost of the Journal of Commerce's basket of industrial commodities is up 10.5% this year for U.S. purchasers, it has risen only 4% or so for global buyers and 1.1% for German buyers. For Japanese purchasers, it has actually fallen about 4.4% (chart).

"The dollar-denominated rise in materials prices," says Lee, "is more related to the dollar's weakness than to escalating global demand pressures. It's premature to worry about global commodities inflation."

A more imminent threat, contends Lee, is U.S. labor costs. In both 1992 and 1993, wage restraint and strong productivity gains kept unit-labor cost increases below 2%. But in 1994, wages have picked up steam, and productivity has started to slow. As a result, unit-

labor costs in the first quarter climbed at more than a 4% annual clip.

Further, productivity could well have declined in the second quarter, causing unit-labor costs to rise at a 3% to 4% rate again. That's because recent strong employment gains imply that the economy would have to have grown at a 5%-plus annual rate just to keep productivity flat, says Lee.

"The real inflation risk," he concludes, "is not commodity prices but the possibility that slowing U.S. productivity growth will push up unit-labor costs."

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