U.S.: Inflation: Tough Questions, Tougher Solutions
Investors, especially those enamored of technology stocks, confronted a shattering realization on the morning of Apr. 14: Even with tech-driven gains in productivity and global competition helping to restrain prices, maybe the New Economy isn't immune to inflation after all. That Friday morning, the March consumer price index showed possibly the first hard evidence that inflation fear had turned into inflation reality.
The focal point was the 0.4% monthly jump in the core CPI, which excludes energy and food. The rise was broad and especially sharp in services (chart). It was the largest monthly gain in five years and seems to confirm reports of newfound pricing power at U.S. corporations.
Stock indexes took one of the worst one-day batterings in the postwar era, including a record drop in the tech-heavy Nasdaq. The sell-off reflected two related fears: that the Federal Reserve may have to hike interest rates more aggressively, and that stock valuations based on low, stable inflation may no longer be valid.
Now investors have to answer some hard questions. First, will the stock market sell-off cool demand and lower the risk of sharper hikes in interest rates? Second, was the March CPI report a one-month fluke, or did it signal a nascent upturn in inflation? The answers may have far-reaching implications, not only for stock prices but also for the future of this expansion. That's because fighting actual inflation can be a lot more painful than simply preempting inflation.
THE BAD NEWS: There is more fact than fluke in the March price data, especially when set against the current backdrop of red-hot demand, drum-tight labor markets, and a recovering world economy. Plus, the rebounds in the stock indexes on Apr. 17 and 18 suggest little diminution in the wealth effect, which has helped to generate the excessive strength in consumer demand that has fueled inflation pressures.
In fact, evidence of increased pricing power is already starting to pop up. A Dun & Bradstreet survey of 3,000 executives finds expectations of price increases have "risen sharply," with 46% expecting to increase prices in the coming quarter. Plus, a survey by the National Association for Business Economics found that higher costs for labor and materials were being passed along to customers. Some 94% of companies said they had already realized planned price increases, the most in four years and "a sharp turnaround in pricing power from earlier surveys," the NABE said.
To be sure, the jump in the core CPI is not as ominous as it looks. An April repeat is unlikely. Note that a 0.4% monthly rise is equal to a 4.9% annual rate, while yearly core inflation is a lower 2.4%. Any upturn will be gradual, given the restraining forces of productivity growth, global competition, and immigration.
But that may be small consolation. The March CPI is saying that those countervailing forces will not blunt inflation altogether. The core rate is already up half a percent since October. And any further upturn will severely complicate Fed policy, possibly putting the economy at risk. If inflation has turned up, then it will continue to rise until the Fed can slow the economy enough to rebalance overall demand, which continues to be powered by consumers (chart).
But that will only put inflation on hold at a higher level. Cutting inflation back to a rate consistent with price stability, generally assumed to be no greater than 2%, will require a period of subpar demand growth. The great debate among economists has been over the growth rate that triggers inflation. But once inflation starts to rise, the dynamics of the process to slow inflation and the pain caused by that process are accepted by economists of all stripes.
SEVERAL KEY MEASURES of core inflation, including the price index for personal consumption expenditures, were turning upward well before March. The Fed prefers the PCE index over the CPI, partly because recent changes in the CPI have given it a downward bias, making an inflation upturn harder to spot. Also, if the large ups and downs in tobacco prices are excluded from the PCE index, it shows that a sharp pickup in core inflation began last fall. The tobacco price swings of late reflect legal, not market, influences.
Services, which tend to be labor-intensive and immune to import competition, are leading the upturn. Core service prices, which make up 70% of the core CPI, jumped 0.5% in March. Measured from a year ago, core service inflation is 3%, up from 2.5% in October, and the pace so far this year is the fastest three-month rate in five years. Inflation in both medical care and shelter, the basic component of housing costs, is fueling the rise. Both are up half a percentage point since last fall, to 3.9% and 3%, respectively, in March. Those two items account for 46% of the core CPI.
Core goods prices, excluding tobacco, remain tame, chiefly reflecting import competition. Soaring imports widened the trade deficit again in February, to a record $29.2 billion (chart). However, the direction of those goods prices has turned. Instead of falling, as they were a year ago, they are now rising slightly. Chalk up some of the strengthening to the turnaround in nonoil import prices, which in the past year and a half have swung from 4% deflation to 1% inflation.
COST PRESSURES, and how companies deal with them, are the key to the inflation outlook. So far, rising costs have come mainly from materials, while labor costs have remained manageable. However, that may be changing. The growth in hourly earnings of production workers has picked up notably so far this year, and higher medical-care costs are sure to push up benefits.
The year's first measure of overall compensation will be the Labor Dept.'s employment cost index on Apr. 27. If economists' expectations for a 1% rise from the fourth quarter are realized, the yearly growth rate will shoot up to 4.1%, the fastest in eight years. Unless productivity growth speeds up further from its already spectacular 3% pace of recent years, some additional upward pressure on unit-labor costs seems likely to develop, as the labor market continues to tighten further.
Clearly, any ability to pass on these cost increases helps profits. Despite rising costs, especially sharply higher energy bills, companies posted generally stellar earnings in the first quarter, based on Business Week's early-bird tally. That, plus double-digit gains in revenues, suggests that a little added pricing power gave profits a lift.
As recently as Apr. 7, Fed Chairman Alan Greenspan described pricing power as "well-contained." But recent company surveys and the March CPI suggest a changing climate. Coincidentally, on May 16, Labor will release the April CPI report just before the Fed's policy meeting. That report could go a long way in determining how hard the Fed hits the economy's brakes that afternoon. It could be a nerve-racking day on Wall Street.