Wednesday, March 30, 2005

So how serious is the inflation bugaboo anyway?

Much of Stephen Roach�s recent worries revolve around the Fed�s need to �catch up� on its monetary retrenchment efforts, with most of the 175 basis points of tightening orchestrated since mid-2004 eaten away by the sudden return of general price inflation. Case in point, Roach from Monday:
Despite nine months of measured tightening, America�s central bank remains well behind the curve, in my view. That is apparent if the �curve� is defined to delineate the setting of the policy rate that would be consistent both with the Fed�s inflation concerns as well as America�s current-account adjustment imperatives. The real, or inflation-adjusted federal funds rate currently stands at just 0.35% if the nominal funds rate (2.75%) is �deflated� by the year-over-year increase in the core CPI (2.4%); it is still slightly in negative territory if the headline CPI (3.0%) is used. An average of the two readings works out to a �zero� real federal funds rate -- underscoring the persistence of extraordinary monetary accommodation.
On the other hand, CBS MarketWatch�s Irwin Kellner is worried about exactly the opposite. To Kellner, a federal funds rate of 2.75% � and more importantly, 30-year FRMs over 6.0% � is about all the US economy can take.
While it's in the process of raising interest rates, the Federal Reserve will have to be careful not to go too far because of the leverage that can magnify the effects of monetary tightness. . . .

Higher mortgage rates will crimp the demand for housing as well as for refinancing existing loans. This means less need to spend on home furnishings, which is just as well, since consumers will have less cash, anyway.

Add to this the fact that consumers have record debt loads -- made manageable only by the existence of low interest rates -- and you can see leverage already beginning to develop. . . .

All this leverage that's out there tells me that the Fed can't get too aggressive, when it comes to raising interest rates. If it does, it may well discover that fighting inflation is the wrong war.
So which is it?

I argued on Monday that consumer inflation is not terribly serious. An article in yesterday�s Christian Science Monitor, ostensibly describing the new inflationary pressures on business, only reinforces my tired old point that the pricing leverage of capital is still very limited thanks to globalization and anemic wage gains by labor. Many cites from the CSM article show as much:
In La Jolla, Calif., Domino's just increased the amount it pays delivery drivers by a nickel a trip: They now get 95 cents to transport a large pepperoni, but it's still not enough to cover the cost, says assistant manager Donald Cunningham. . . .

Thanks to that competition for consumers, combined with the concurrent growth of cheap imports, most people have so far been sheltered from that impact.

"I can still go online and I can order a TV set or a pair of pliers or some other gadget and still get free shipping, if I'm careful," says Mr. Routt. "That, however, can't last forever." . . .

A decade ago, truckers spent roughly 17 cents per mile on fuel; today they pay 35 cents. While there is a surcharge that truckers can pass along to the shipper, Mr. Daniel said that often the charge is pocketed by a broker or not charged at all.

Eventually, he says, truckers are going to have to start passing those increases along. . . .

While some people are looking to economize on gas, some businesses are having to continue to absorb the higher costs, even though they're now cutting deeply into the bottom line. . . .

the airlines themselves, many of which are in bankruptcy or battling to avoid it, have also been reluctant to pass along the higher price of jet fuel, at least on the domestic front. That's where the major legacy carriers face fierce competition from the low-cost carriers, and they're determined not to lose more passengers to them. But the majors are now slapping large fuel surcharges on international travel, where there's less competition. It's one of the few ways they're hoping to increase revenues as they face their fifth straight year of multi-billion dollar losses.

Differences between PCE and CPI inflation are showing the same thing more convincingly. CPI inflationfrom January 2004 to January 2005 was running at a notable 3.0% and core CPI at a somewhat milder 2.3%. PCE inflation over the same period, however, was a still tamer 2.2% and core PCE inflation was running at just 1.6%. In that the PCE index picks up consumer substitutions of cheaper products for more expensive ones while the CPI does not, the significant difference between PCE and CPI inflation shows that consumers really are keeping price increases low by shifting their purchases to the lower end of the quality scale.

Where we really see inflation is in asset prices, especially housing. The Fed�s worries about US inflation have to be more about asset inflation than consumer price inflation, much like the concerns of the Bank of England where UK housing prices are into the stratosphere while CPI runs at a mere 1.6%. Yet slaying the asset inflation dragon may also send the US consumer packing. Asset price inflation is about the only thing -- apart from oil prices -- keeping US inflation safely above the 1.0% danger zone. A quick strangling of the US housing market could drive us back to the deflation scare of late 2003. And yet letting the asset bubble continue to swell only make the unavoidable landing harder.

When looking at both the US current account deficit and the US housing market, the clear choice of all policy makers is to delay the pain on the belief that present suffering is always worse than future suffering � which of course makes that final day of reckoning a little further away and yet all the more terrible.

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