During the past week I’ve been trawling through spreadsheets and trying to make sense of CPI, PPI and wages data. The reason that I put myself through this ordeal was to try to understand why on earth would the ECB hike rates right now, but then I ended up looking at US data.
Of course the stated 2% inflation target has been breached so maybe they felt they had to act to maintain their credibility.
Many people draw parallels between the current situation and the 1970s oil crises, but I think that things have changed quite a bit since then. The real game-changer for me is free-trade or freer trade if you prefer.
|source: Federal Reserve Bank of St. Louis|
The above chart illustrates that point pretty eloquently in my view. As you can see until the 1970s, CPI lagged wages’ growth. Since the US had tariffs on most imported products there was a relative liberty of defining wages without worrying about being competitive, the tariffs took care of that.
But after the 1970 things changed. The relationship between the two has become less obvious and less close. After 2006 some form of relationship seems (to me) to be emerging again, a different one at that, with wages appearing to lag CPI.
|source: Federal Reserve Bank of St.Loui|
What interests me the most right now though is the way wages and CPI behaved during the twin crises in the 70s. While until then CPI lagged wages, during the crisis, when it became evident that oil prices had significant momentum, wages started lagging CPI. The relationship changed rather abruptly.
If the inflation spree that we were witnessing was demand-side then the ECBs decision would seem more justified to me. Then the main transmission channel, which I think is wages, would grow and ensure that inflation can indeed be a problem. But supply-side inflation, which is usually driven by spikes in commodities prices, has to go on for a significant amount of time in order to affect wages meaningfully. During the most recent oil shock, in 2008, wages growth lagged was significantly lower than the CPI spike. Especially, in the beggining of a tightening cycle that is not demand-driven, hence firms' revenues growth could be more sluggish, raising the firms' interest expense could bring price raises closer.
Since the point of this post if US inflation, talking about the ECB means straying from the point, I'll just say that the current hike's impact should be limited but further hikes could prove more damaging and end the ECB reference here.
I have another chart for you now, I have plotted PPI (Producer Price Index) and CPI. One thing that is obvious at first sight is that when PPI gets out of hand then producer cannot pass through the whole increase to the consumers. Another trend that seems clear to me is that for every large spike in PPI the ensuing spike is CPI is tremendously smaller than it used to be. The obvious reason for that is free trade that gives producers less room for maneuvers since there is always the threat that they’re going to lose market share or something else.
|source: Federal Reserve Bank of St. Louis|
The wild card is how long unrest in MENA will go on for and what other consequences (unforeseen or not) will it have. Even if the worst case scenario materializes and it drags on for a long time (does that seem unrealistic to you?) in the logic of what I mentioned above, one would expect inflation not to reach levels witnessed in the 70s.
I’d like to share a thought with you. During the previous two years, US corporations have gone on a cost-cutting spree, which means that they are a bit pressured at the moment. Every rise in costs could be a direct hit for their margins. What does that mean?
In my humble opinion, it means that firms could be forced to raise prices more than they would in the case that cost-cutting hadn’t took place. If you notice the second oil shock in the 70s you can probably see that CPI rose almost as high as PPI did. Was this due to cost-cutting that took place in the first oil shock which made firms unable not to roll-over rising costs to end-consumers? Well, I wasn’t around back then so I don’t know, I’m just wondering.
On the other hand, the US consumer is gutted right now, the larger part of the population is still deleveraging, one just has to look at revolving credit evolution to realize that, which at the same time speaks volumes about private consumption’s strength. This fact makes firms reluctant to raise prices by much since it could lead to demand destruction for most sectors.
These two facts push at opposite directions. The outcome of this struggle along with all the geopolitical events taking place will define how high CPI goes…
P.S. The point where most forecasts fail is when the trend changes. On the other hand, when the trend is in tact, most forecasts are more or less accurate. As far as inflation in concerned I think that there will be a change in trend in the future and that we will go into higher average inflation. I believe that this will happen when there will be no more goods or services that western nations can produce more efficiently or in higher quality than former emerging markets (EMs). This is bound to result in a reverse trend in free trade. Already a rotation of produce among EMs is taking place. These are clearly wild thoughts and fantasies and most probably are way off the mark, I still wonder though...