March 24 (Bloomberg) -- There’s one economic aspect of Japan’s earthquake, tsunami and nuclear disaster that seems to be getting lost in the rubble, and that’s the effect on prices.
Yes, prices. Remember them? You’d never know it from the analysis of what Japan’s triple-whammy means for the domestic and global economy.
A natural disaster qualifies as a supply shock. For the graphically inclined, this is represented by an inward shift, to the left, of the supply curve. It describes what happens when producers provide fewer goods at any given price than they did before. The result is lower output and higher prices.
An increase in prices may be a desirable outcome for Japan’s policy makers, who have been battling mild yet persistent deflation for more than a decade. It may not be optimal for others.
The European Central Bank was already making noises about raising its benchmark rate, currently at 1 percent, at its April meeting before disaster struck. Recent comments by ECB officials suggest Japan’s crisis hasn’t changed their thinking.
With inflation running at 4.4 percent in the U.K., investors expect the Bank of England to raise its base rate by 25 basis points in July, according to forward contracts on the sterling overnight interbank average.
Shocked by Supply
The ex-post analysis of Japan’s devastation is similar to that following Hurricane Fill-In-the-Blank (Katrina, Andrew, Floyd), which invariably focuses on the hit to spending and economic growth.
In other words, what is really a supply shock resulting in higher prices is viewed as a damper on demand, which would have the opposite effect.
The first-order effects of natural disaster are a loss of income, production and output. If a factory is destroyed, employees can’t report to work. Production is halted, and cars stop rolling off the assembly line.
If regular distribution channels are disrupted, manufacturers have to find alternate (read: less efficient, more expensive) means of transporting goods from one place to another. Prices rise.
Japan fits this model to a tee. Toyota, Honda and Nissan, the three largest Japanese auto manufacturers, halted operations at many plants following the earthquake and power disruptions, and are only now starting to restore production.
The effect isn’t limited to Japan, which is a net exporter. A shortage of Japanese-made parts, especially electronic components, forced General Motors to suspend production or cut shifts at facilities in the U.S. and Europe. Just-in-time inventory management means just-not-enough parts on hand to ensure a normal pace of production even at functioning facilities.
Prices are behaving as expected, with computer chips spiking after the earthquake. Japan produces about 20 percent of the world’s semiconductor chips and 60 percent of the silicon wafers that go into them.
Auto prices will soon follow suit. Edmunds.com, a source of information for car buyers, offered this advice: “There is no downside to buying now -- and plenty of potential upside.”
High gas prices are expected to increase the demand for fuel-efficient cars, including hybrids. All Japanese-brand hybrids are built at home, according to Edmunds.com.
The confusion between supply and demand doesn’t end with output and prices. The initial reaction to a supply shock is to look to central banks to cushion the fall. The banks are generally happy to oblige, in part to ensure the smooth operation of the financial system. The Bank of Japan has pumped a record amount of cash into the system since the March 11 earthquake.
The problem isn’t weak demand; it’s reduced supply. Central banks manufacture one thing: money. They can’t produce computer chips, electronic components or automobiles.
In other words, they can’t make up for the lost supply. All they can do is print money so that more money chases fewer goods and services, which is the definition of inflation.
In the U.S., Federal Reserve Chairman Ben Bernanke plans to let QE2, the second round of quantitative easing, play itself out to its stated conclusion in June -- even with deflation fears evaporating.
The U.S. consumer price index rose 0.5 percent last month and 2.1 percent year over year. While the primary drivers were big jumps in the prices of energy (up 3.4 percent) and food (up 0.6 percent), the increases were “broad-based,” according to the Bureau of Labor Statistics.
Among the major categories, only apparel posted a decline. The indexes for shelter, transportation, medical care, recreation, and education all rose last month.
To the Core
The core CPI, which excludes food and energy, rose 0.2 percent in both January and February, the biggest back-to-back increases since September-October 2009. The year-over-year increase rose to 1.1 percent from an all-time low of 0.6 percent in October while the three-month annualized increase jumped to 1.8 percent.
Not scary numbers, to be sure. But “the worm appears to be turning on inflation” is how Ward McCarthy, chief financial economist at Jefferies & Co., described it when the February CPI report was released on March 17.
Monthly 0.2 percent increases in the core CPI would drive the year-over-year increase to 1.5 percent by May and 2 percent by September.
Exit strategy, anyone?
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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