The Changing Shape Of Inflation

Although there's no reason to start hoarding cat food yet, it is time to start thinking about inflation again. For the first time since the 1970s, when OPEC dealt the U.S. economy an unexpected blow by hiking oil prices, another outside power -- China -- is having a surprising impact on America's economic life.

OPEC unleashed inflationary and deflationary forces, which confused policymakers and ended the 1960s era of high productivity growth. Today, China is sending inflationary and deflationary price pressures into the U.S. economy, and it's unclear how this will affect growth. The conventional wisdom is that inflation will remain tame. Probably so. But the shape of inflation is changing, and we should examine it.

We know that commodity prices are rising sharply. Oil, copper, steel, coal, cement, and lumber are up, some jumping 60% to 100% recently. We also know that import prices are rising and that pricing power is returning to some retailers and manufacturers. The consumer price index rose unexpectedly in January, with seven components rising -- gasoline, fuels, education, water/sewer and trash collection, medical care, food, and personal services.

But we also know that the prices for many things are falling. Indeed, six components of the January CPI dropped -- personal computers, used cars and trucks, telephone services, clothes and shoes, household furnishings, and new vehicles. Unit labor costs are falling, and wage growth is slow.

A booming China appears to be pushing up prices for commodities while at the same time pushing down prices for goods and factory labor via cheap exports. Outsourcing to India is pushing down wages in services. Until recently, the two price pressures -- inflation and deflation -- nullified one another. Now there appears to be a shift toward inflation.

How will inflation play out ahead? There are several wild cards to watch, including OPEC and terrorism, but China is critical. Money supply is growing at 20%, a year and wages in Shanghai and on the coast are rising at 10%. In 2003, prices were falling. Today they are rising by 3.2% annually. If China exports more inflation and less deflation, the U.S. could suffer.

Then there is the dollar. In 1985-87, it dropped 20% on a trade-weighted basis, inflation rose, and foreign investors stopped buying stocks and bonds. The dollar is now down 17% and poised to fall further when China revalues the yuan.

The U.S. and China appear to be at an inflection point. China has moved from deflation to inflation in the space of a few months without much notice, and the U.S. is following. Something is happening. We should take notice.

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