The Inflation Genie – Still out of the Bottle

Today’s Producer Price Index data show emphatically that the inflation genie has yet to be stuffed back into its lamp. The monthly change in finished goods prices for July was 1.2%, which was twice the consensus estimate of economists, and it increased 9.8% year-over-year from June 2007, keeping a steady uptrend intact.

Also worrisome is that crude and intermediate goods prices still show upward pressure, which implies higher prices in the pipeline. In August, our indicators did begin to signal that inflationary pressures will moderate a bit, so we expect the PPI to soften some in coming months. However, an important caveat is that they are still relatively high, and inflationary pressures have not yet fed through fully into the overall level of prices.

It continues to be our view that inflation, income, and asset price trends are echoing the 1970s, and on that point, we find ourselves in agreement with Merrill Lynch economist David Rosenberg* who recently remarked:

We’re heading into…the onset of the first consumer recession since 1990-91. I would argue that this could end up being very similar to that six-quarter consumer recession that we endured from 1973-75. There are differences, but there are similarities. A lot of people like to compare this to [1990-91], because of the real estate flavor and credit crunch, but there is actually a lot more going on that compares it to 1975…

What is the cash flow drain on the household sector from [credit contraction, asset deflation, and higher unemployment] in the coming year? The answer is $800 billion…That is a huge number. It’s equivalent to 12% of discretionary spending, which, by the way, is exactly the peak-to-trough decline in real consumer cyclical spending back in the 1973 to 1975 recession.

Clearly, U.S. households are in for a long period of balance sheet repair. Unfortunately, it’s going to unfold against a backdrop of likely government policy directions–in the form of rising taxes, mandates, entitlements, regulations, and trade barriers– that will make the process more difficult and time consuming. This will in turn pressure the Fed to address the resulting economic damage with easy monetary policy, which will keep a match under global inflation.

Meanwhile, many U.S. policymakers and economists have been reassuring themselves that, unlike the 1970s, there isn’t going to be a "wage spiral" in the U.S. that will cause inflation expectations to become unhinged, to which we would point out the obvious: any imminent or ongoing wage spiral is going to happen (or is already happening) overseas; it’s going to be exacerbated to the extent that major central banks use monetary easing to combat domestic slowdowns; and it will shake up inflation expectations eventually (indeed, it already has in many parts of the world). As Morgan Stanley strategist David Darst pointed out recently, "the inflation rate for 42% of the world’s 6.5 billion people is over 10%." How wage spirals will play out in disparate institutional frameworks acoss different countries and regions remains to be seen (in the U.S., it was largely accomplished through union activities). We don’t expect the process to be simple or uneventful.

What sort of adjustments might occur in the U.S., assuming we don’t see rising wages? One clear possibility is a longstanding consumer recession of the kind described by Bernstein. Less obvious, but based on clear demographic realities, is the likelihood of a "benefits spiral" in the U.S., be it in Social Security, pensions, Medicare, health benefits, or elsewhere. We could eventually see taxpayer  and/or shareholder revolts, and even more stubborn retrenchment in consumption among pre-retirees.

Many of these problems could be ameliorated with the right policy mix–lower taxes, regulations, and tariffs, in concert with a stronger monetary stance from the Fed. Unfortunately, this outcome seems highly improbable in the near future, leaving us to repeat our current mantra: Not good…

* The comments from David Rosenberg posted at the Investors Insight web page are transcribed from a recent conference call–if you read it, be aware that there appear to be some transcription errors that could cause confusion.