Inflation Down

For the first time in this Parliament, CPI inflation has fallen from 3.5% in March to 3% in April. For the record, RPI inflation fell from 3.6% to 3.5%.

This also means that it is the first time the George Osborne has not received a letter from the Governor of the Bank of England, to explain why the inflation target has been missed. An open letter is triggered if the CPI rate remains above 3% or below 1% for three months in a row.

Drinks all round!

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The weakness begins

- by New Deal democrat

With the release of producer and consumer inflation figures yesterday and today, it is safe to say that the period of maximum weakness forecast by the downturn in the long leading indicators over a year ago has begun. Notice I didn't say "recession." Neither the increase in initial claims yesterday, nor the inflation data, causes me to re-think that position I just re-examined within the last month (a period of weakness now, followed by relative strength later in the year). But weak data is likely to persist for several months at least.

First, let's briefly look at initial jobless claims. Prof. Dean Baker says not to panic, the increase is due to the non-winter winter distorting seasonal patterns.

That may be true, but on the other hand, there may be a different seasonality at work. The below graph includes the last 2 years of claims, and highlights April through June last year and claims since April 1 of this year in red:



It may be that the recent re-jiggering of seasonal adjustments was incomplete, or it may reflect increased layoffs due to the seasonal increase in gasoline prices tightening the choke collar on the economy.

Next, let's examine commodity, producer, and consumer prices. What is noteworthy is that, after a period of heightened commodity and producer price inflation, those are now declining on a YoY basis to the point where they are equal to or below consumer inflation. As of today, YoY CPI is +2.7%. YoY Commodity inflation is now +2.6%, and producer prices YoY are +2.8%. In the past, as I will describe more below, when the rate of commodity and producer price inflation goes from higher than to lower than consumer inflation, it has almost always coincided with weakness.

The inflation data isn't leading, it is coincident. But by examining the last few periods of weakness, we can get a very good idea how long it is likely to persist. (Note: the graphs below do not include this morning's CPI data).

First of all, here's a look at YoY consumer prices (blue), finished producer prices (red) and commodity prices (light green) since 1996 (note: I've divided the change in commodity prices by 2 for better scale only):



Notice that there have been 4 periods of relatively weak commodity and producer prices since 1996. Notice further that just prior to both recessions since then, commodity and producer prices ran much hotter than consumer prices. They crossed consumer prices about 1/3 of the way into each recession, and each recession ended when YoY commodity and producer price changes were at their lowest. This by the way is also exactly the pattern for the pre-WW2 deflationary recessions, including both the Great Contraction of 1929-32, and the Recession of 1938. That YoY commodity and producer price changes have now become weaker than YoY consumer prices tell us we have entered the period of maximum weakness.

In the next few graphs, I've subtracted producer prices from consumer prices. Thus a negative reading is a period when producer prices are growing faster than consumer prices. In the first, these are compared with YoY GDP (red):



Negative readings don't always mean negative GDP (remember the importance of consumer debt refinancing at lower rates). But when producer and commodity prices suddenly become weaker than consumer prices, at minimum a bout of weakness (1998, 2002, 2006) if not recession (2001, 2008) follows.

Next is the same relationship, except that the comparison is with quarterly changes in GDP:



When we make this substitution, we get a noisier relationship, but on the other hand you can see that quarterly GDP changes track the relative weakness or strength of consumer vs. producer prices very closely, as in only one or two quarters later.

Since it is weakness in inflation-adjusted wages that in part triggers the economic weakness, next let's compare real wages (red) with producer vs. consumer prices:



Note that once again, while there is noise, the two tend to move in tandem. Thus as producer prices weaken, we should expect to see real wages improve.

How long will the weakness last? As I've repeated above, the weakness bottoms almost exactly when producer and commodity prices are at their YoY weakest. That isn't as difficult to predict as it may seem. In each of the 4 periods of relative weakness since 1996 shown in the first graph above, the weakest point came within one month of exactly one year after the highest monthly producer and commodity price reading. The last 5 years of commodity (red, dividing by 2 for scale) vs. consumer (blue) price changes are shown in the bar graph below:



In 2008, the last strongly inflationary month was July. Barring a deflationary spiral, it wasn't too difficult to foresee that the maximum YoY reading in commodity prices would be July 2009. Based on past deflationary recessions, including the Great Depression, that meant the "Great Recession" was likely to bottom in about that month. That was a strong contributing factor in my ability to foresee when that recession would bottom in advance.

In 2011, the last strong inflationary month was April. Unless there is a severe recession, it is unlikely that YoY commodity prices will continue to decline after July, or September at the latest. Better real wages and improving business profitability caused by the greater decline in commodity prices should assert themselves beginning at that time. That means this period of weakness should start to abate sometime during the summer -- i.e., too short and too shallow to be considered a recession.

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1955: Interest Rates, Inflation and Fed Policy

 

Remember that during 1955,  the economy was growing at very strong rates.  As the economy expanded, businesses increased their borrowings.  In addition, as the economy expanded, the Fed became more and more concerned with inflation.  This is the reason for the increase in the discount rate during the year.  Consider the following excerpts from various rate decisions by the Fed:

From April 13: 

August 3:

November 17:

However, prices were in fact pretty contained:

The bottom whole sale price chart shows that crude goods were decreasing in price.  The real price pressure was coming at the intermediate price level, but producers were able to absorb that cost, as evidenced by the slow rise of finished goods prices.  The top chart shows that food prices were dropping sharply, while other prices were moving higher.

Consumer prices were also pretty contained.  The primary area where we see an increase are in services, which is to be expected; this year -- and this decade -- saw a tremendous increase in service usage on the part of consumers.  As the US started to form households, they purchased more and more goods such as dry cleaners, yard services etc....

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1950s: The Discount Rate and 1950 Inflation

The above chart shows the Federal Reserve's Discount Rate for the 1950s.  Note that in the middle and end of the decade we see the Fed increasing rates to such a degree that they create a recession.  Then we see the Fed lower rates during the recession to spur growth.  This is what most people think of when they think of "recession and recovery."

That being said, let's take a look at inflation in the year 1950, as it explains the increase in the discount rate.

PPI continued to increase on a YOY rate, eventually reaching nearly 15%, while CPI continued to escalate as well, eventually hitting hear 6%.  So -- what caused these price increases?

1.) Massive demand.  PCEs increased at incredibly strong rates for the first three quarters of the year.  This led to a classic case of demand pull inflation.  Food prices were a big reason for the increase (which increased 4.8% from December 1949 to November 1950), as was an increase in house hold furnishings (which increased 9.1% from December 1949 to November 1950).

2.) The Korean War outbreak led to massive increases in raw material prices.  As the ERP notes, 75% of industrial goods had increased in price by mid-October, 44% had risen 10% or more, and 26% were up 20% or more above the pre-Korean war levels.

As an aside, here are the charts from the Economic Report to the President for both Whole
sale and Consumer prices.

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The Great Energy Rip Off

Energy companies regularly use rising wholesale prices as a justification for why they raise energy bills for customers.

However, the calculations by which the "justify" their price increases are utterly incomprehensible. As such OFGEM have hired forensic accountants to scrutinise the wholesale fuel prices paid by the "Big Six" energy companies.

Given that OFGEM can't understand the pricing structure of the energy industry, how are we poor saps (the end users) meant to understand it?

Q: Why do the energy companies make it so complicated?

A: RIP OFF!

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Monetarism Rules!

The IMF has given guarded support for the government's plans for reducing the budget deficit (currently £4.8 Trillion).

The IMF's crystal ball gazers are of the view that the economy remains on track for a "moderate" recovery, if interest rates remain low and inflation eases.

However, the IMF also stated that if the high risks of an ongoing slump continue; then the economy should be stimulated with a combination of more quantitative easing and temporary tax cuts.

In other words, the economy may well need a monetarist stimulation rather than a Keynesian one.

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Interest Rates Hold Steady

As predicted the MPC have not raised interest rates, they remain (as they have done for the past 27 months) at 0.5%.

The decision to freeze rates is hardly surprising given the state of the economy and level of indebtedness.

However, do not expect the ECB to be so "alive" to the economic problems of the real world. It is highly likely that the ECB will continue to tilt at windmills, and push for higher rates, in its fanatical and mistimed battle against inflation.

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King Warns On Rate Rise

Mervyn King, Governor of the Bank of England and deputy chair of the European Systemic Risk Board (ESRB), issued a warning whilst speaking yesterday at the European Parliament that a rise in long-term interest rates would have "severe" consequences.

King's rationale being that the level of indebtedness would be increased by any rise in rates.

Given that the comments come ahead of this week's MPC rate setting meeting, it is being interpreted as a signal that UK rates will remain at 0.5% for the time being.

Whilst the MPC may well see the dangers of an increase in rates, no such "real world" understanding is apparent in the actions and attitude of the ECB who fear only inflation and ignore recession. Sadly for the people of Europe, the ECB are determined to press forward with higher rates irrespective of the damage that these increases will do the the European economy and to the citizens of Europe.

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Inflation Falls

The Office for National Statistics (ONS) report that consumer price inflation (CPI) fell to 4% in March, contrary to the expectations of "experts" who were looking for a figure of around 4.4%.

Retail price inflation (RPI) also fell to 5.3%.

The reason for the fall is being attributed to the price war being waged between supermarkets, which has pushed down the cost of food and drink. Additionally, the rise in VAT has probably now worked its way through the system.

It would be folly indeed, given the poor sales figures being reported by the high street stores, for the Bank of England to raise interest rates in the near future.

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Real Incomes Fall

The Office for National Statistics (ONS) reports that "real" incomes fell by 0.8% in 2010, from £14,181 per person to £13,980.

This is the first drop since 1981.

The fall, according to "experts", is due to salaries being eroded by inflation (something that the man in the street could have told the "experts" months ago).

The fall will add to the sense of gloom amongst consumers, and will inevitably hamper any possible growth in the economy.

However, as with all statistics provided by the ONS, these figures should be taken with a pinch of salt. Statistics from the ONS are always late, and invariably have to be adjusted some months after publication.

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Inflation Own Goal

On the eve of the Budget, allegedly one designed for "growth", George Osborne has been hit by the unwelcome news that CPI inflation has risen to 4.4% in February and RPI has risen to 5.5%.

This of course, as I have noted before on this site, is not unexpected given that VAT was raised to 20% in January.

As such this inflation is an own goal scored by Osborne.

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Three eras of Inflation

- by New Deal democrat

If you would like to donate for Japan relief, here is a link to the Red Cross..

This week we will get February's producer and consumer inflation readings. While a lot of attention will be paid to food and energy prices, the overall allocation of commodity price increases between producers and consumers has received little attention. While the variation in any one month appears trivial, the long-term trajectories of producer vs. consumer prices tell an important story about how much of the burden has been borne by consumers vs. how much has been retained by producers. Since World War 2, there have in fact been three eras of inflation.

In the post WW2 "Great Compression" of incomes, where the middle and working class fully shared in America's prosperity, producer and consumer prices moved generally in lockstep. With the exception of the Vietnam war inflation of the late 1960's, producer inflation (red) - and only that inflation - was passed on to consumers (blue):



The came the Reagan era of the "great moderation" and of the 18 year bull market in stocks, in which declining interest rates, automation and offshoring meant that producer price increases were kept to a minimum, and consumer prices increased far beyond those paid by producers. Put another way, in inflation terms the middle and working classes were gouged:



By about 2000, consumers had reached the end of their rope. Only easy credit fueled a temporary binge during the Bush years. Producers have been unable to pass on price increases to consumers, for the simple reason that consumers can no longer afford them:



This is why I do not see a general inflation (as opposed to Oil price inflation) as a threat to the economy. Producers who increase prices due to commodity price increases will be met with a downturn in consumer demand (just as happened in 2008). They won't recoup their losses, instead some of them will go out of business. Those who are able will increase the hours and obligations of salaried employees, or hire new workers at lower wages than before. Inflationary spikes will be temporary and will be quickly offset with a deflationary response. In milder cases this will lead to a slowdown as during last summer. In severe cases there will be another deflationary bust.

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UBS Shoot Themselves In The Foot

UBS claim that supermarkets have been increasing their prices by 6%-6.5%, despite the fact that commodity price inflation indicates that rises should only be around 3%3%-3.5%.

The Telegraph quotes Paul Donovan, a UBS economist:

"That suggests there may be margin expansion in the supermarket sector… Prices are rising in excess of justifiable cost increases."

However, UBS then go to shoot themselves in the foot by noting that only 20%-25% of the price reflects the "commodity input".

A British Retail Consortium spokesman put the boot into the UBS report, by noting:

"There is no question that in the UK, customers pay less for their food than is the case in most other European countries. Food prices have not risen at anything like the same rate as commodity prices. It is clear that supermarkets are shielding customers from the full impact."

It would seem that UBS have tried to use the report to garner themselves some headlines. Unfortunately for UBS, the headlines that they have garnered are not particularly favourable to them.

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The Miguided Hawks of The MPC

The Telegraph reports that according to the latest MPC minutes, released today, the Bank of England chief economist Spencer Dale has joined Martin Weale and Andrew Sentance in calling for an interest rate rise.

The "hawks" deem inflation to be a significant threat to the economy.

They are wrong:

1 The impact of the austerity budget has yet to be felt, once that kicks in there will be a significant deflationary pressure on the economy.

2 The economy is teetering on the edge of another recession, any upward increase in interest rates will push the economy over the edge.

3 An inflation rate of 4%-5% is bearable for a year or so.

4 The "inflation" that the MPC hawks fear is largely down to the rise in VAT in January, and the ONS (as per usual) erroneously under reporting inflation (clothing) for several years.

In short, rate should be kept where they are for the time being.

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Inflation

Andrew Sentance, a member of the Bank of England's Monetary Policy Committee (MPC), has broken ranks and publicly accused (at a speech at the Institute for Economic Affairs) Mervyn King and fellow members of the MPC of "selling Britain by the pound".

Sentance is of the view that King and the Bank are far too optimistic about how quickly inflation will fall back to its 2% target, and believes that the MPC has delayed for too long raising interest rates.

He is to my view wrong, any rise in interest rates now before the effects of Osborne's austerity budget kicks in will risk pushing the British economy "over the edge" into another recession. The economy can withstand a short term inflation rate of between 4%-5%, most certainly as there will be strong downward pressure brought to bear on it by the austerity budget.

The MPC should hold its nerve, and keep interest rates as they are for the foreseeable future.

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Inflation Up

Depending on whether you follow the Consumer Price Index (CPI) or Retail Price Index (RPI) as a measure of inflation, the ONS reports that inflation in January was 4% and 5.1% respectively.

The Bank of England's target for CPI is 2%, as such there is increased pressure from some quarters on the Bank to raise interest rates in order to tackle the inflationary bubble that appears to be forming in the economy.

However, the reality is that if the Bank ups interest rates the economy (which has yet to be hit by the austerity budget) will be sent into free fall.

The Bank should hold its nerve, and wait for the effects of the austerity budget to kick in.

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Dark Days Coming

Yesterday's lousy "growth" figures (a fall of 0.5% in GDP) have heralded further bad news. Minutes from January's MPC meeting show that two members voted for an increase in rates, they must be mad.

The mood of gloom surrounding the economy was further depressed by a speech made last night by Mervyn King (Governor of the Bank of England), in which he said that wages will have to fall and that we are facing the worst economic conditions for 90 years.

I wonder if George Osborne has actually factored all of this into his economic plans?

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Inflation

The Office for National Statistics (ONS) reports that the annual rate of CPI (inflation) has risen from 3.3% in November to 3.7% in December.

These figures will be used by some to push the MPC into raising interest rates.

However, given the shaky state of the economy, any rise in rates should not take place until a commitment from banks and lending institutions (who already charge significant rates on loans/debts) that they will not use a rise in rates to extort further money from people already heavily in debt.

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VAT Increase

As the VAT increase of 2.5% kicks in today, George Osborne is spinning the tale that this is necessary in order to tackle the budget deficit.

I would agree that the budget deficit needs to be tackled. However, I make the following observations:

1 The debt of the UK stands at £4.8 Trillion, it will take much more than a 2.5% increase in VAT to tackle that.

2 As with decimalisation in the early 1970's, retailers will use this VAT rise as an excuse to round up prices. The result will be, as in the 70's, an inflationary bubble.

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Inflation Near To 2% In Two years

The Bank of England has stated that, in its view, inflation will be near to the 2% mark within the next two years.

This view is contrary to some of the prophets of doom who have recently been predicting (for media sound bite purposes) that interest rates will have to be raised significantly (8%), in order to counteract an inflationary disaster.

Additionally, given the better than expected growth figures for the UK economy, the Bank has held back from another round of quantitative easing (unlike the Federal Reserve).

This, in terms or international politics, is probably no bad thing. The US QE2 package of $600BN has provoked a barrage of criticism from both Europe and Asia Pacific, and brought the world one step closer towards "currency wars" (capital restrictions, protectionism etc).

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