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Economy in Brief

U.S. Inflation Pressures -- Demand-Pull, Cost-Push & Money
by Tom Moeller May 21, 2008

Worry abounds that inflationary pressure has built in the U.S. Indeed, the Consumer Price Index rose 4.5% at an annual rate during the last six months versus a 2.9% increase during all of last year. Typically, however, underlying price pressures do not build overnight.

It's handy to look at the "core" CPI to gauge those underlying pressures, and the news is not bad. The 2.2% rate of six month increase in core prices is down from a 2.3% rise last year. Though this simple measure does approximate what rate price inflation will return to after some short term shock has passed, it also misses the underlying process that generates longer-lived price pressure.

Real worry about pricing power should focus on pressure from any one of three fronts, the first is from demand-pull forces. They can be thought of as how fast is economic growth, on a medium term five year basis, exceeding its potential? The latter is measured by adding labor productivity growth to the growth in the labor force.

From this perspective, there has been little buildup of price pressure. Productivity growth during the last five years averaged 2.3%. When added to the 1.0% growth in the labor force that's generating the productivity, the resulting potential for overall real economic growth of 3.3% even exceeds slightly the 2.9% GDP growth rate averaged during the past five years.

The second source of potential pressure is from cost-push pressures. Here is where current concerns about inflation are rampant. Commodity prices have shot higher with surging prices for energy, foods and metals. Overall these components account for a quarter to one third of a product's retail price with the rest coming from processing and distribution. As an aside, these increases have been quite sufficient to squash corporate profitability. The recent 2.4% year-to-year growth rate profits, as of 4Q08, is well off the 24.0% rise during 2004 and well off the double digit gains logged during the last five consecutive years. During the last two quarters, profits have fallen at an average 8.7% annual rate. With a few exceptions, that's a decline of recession proportion.

And indeed, labor costs have risen as shown by 5.0% growth in compensation last year which was up from 4.0% growth during the prior several years. But again, workers seem to have earned the higher pay by working more productively. Nonfarm productivity grew 3.2% during the last four quarters versus 1.8% growth last year and 1.0% in 2006. That improvement limited the growth in unit labor costs to 0.2% during the last year, down from 3.0% in 2006 and 2007.

But whether costs get passed along to consumers, and sustained, depends on two things. The first is whether the economy is strong enough to support faster price increases. The recent slowdown in economic growth to 0.6% (AR) during the last two quarters is well off the 2.0-3.5% growth averaged during the last five years. While the forecast for growth from the National Association for Business Economists projects improvement during the next year, it doesn't ramp up to a barely inflation-neutral 2.7% rate until 2Q09. Additionally, global forces need examination and growth is up slightly. In the OECD economic growth during the last ten years averaged 2.6%. Last year it was a slightly quicker 2.8% and was 3.1% in 2006. The nature of the global relationship between growth and prices is examined in Globalization, Aggregate Productivity, and Inflation from the Federal Reserve Bank of Dallas.

The third, and probably the more important, factor which will determine price inflation (with a lag) is liquidity growth, i.e., money. The basics behind this relationship are examined in this 1976 paper from the Federal Reserve Bank of St. Louis and the recent picture should not be disturbing. Narrowly defined money (M2) in the U.S. during the last year did grow 6-6.5% and it was enough to raise the three year growth rate to 5.5%. That was up moderately from 4.2% as of 3Q06 but still well below 8% growth back in 2003. Growth in bank reserves has been even weaker. The St. Louis Fed's adjusted monetary base last year grew 1.2% and 2.4% on a three year basis, well below the 6-8% rates of growth earlier this decade. Finally, non-borrowed bank reserves fell 3.1% last year. The liquidity to fuel higher prices just seems not to be there.

Despite any good news about the prospect that inflation will remain contained, consumer's aren't buying it ... for the time being. The University of Michigan's May survey indicated that the expected twelve month rate of consumer price inflation rose to 7.0% from a low of roughly 4.0% from 2005-2007. Yet expectations for the five to ten year rate of inflation rose much more moderately, to 3.8% from lows in the 3.0-3.5% range earlier this decade.

Is it possible that the U.S. consumer's long term price expectations reflect the potential suggested by the demand-pull and the liquidity forces outlined above and that the short term expectations are formed by the cost-push pressures? In a word; probably. After all, the consumer has been called "rational." With luck the current expectations are right.

The data behind the comments above can be found in Haver's USECON, USWEEKLY, SURVEYS, UMSCA (Michigan Survey) and the OECDMEI databases.

The minutes to the latest FOMC meeting can be found here.

The Federal Funds Rate in Extraordinary Times is today's speech by Fed Governor Kevin Warsh and it is available here.

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