Inflation Watch

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Inflation Watch

In the past month seven different regional Fed presidents have given speeches containing an inflation warning. It is not often that so many Federal Reserve Bank presidents speak so publicly and with such unanimity on a single topic. But it should be obvious that the Fed is worried about inflation, and for good reason. Inflation is a little like weight gain. It sneaks up on you when you least expect it. You gain a pound here and a pound there, then comes the holiday season and, wham, before you know it you're 10 pounds overweight. Losing that weight is always a lot harder then gaining it. And so it is with inflation.

Highways and Disaster Relief

Disasters of any kind are always inflationary. Disasters destroy the supply side of the economy while giving a boost to demand. Over 1 million barrels of U.S. oil production was still off-line six weeks after Hurricane Katrina blew through the Gulf of Mexico. The result has been soaring prices for energy. While gas prices are up sharply, natural gas prices have nearly doubled from a year ago. As a result, the share of consumer spending for energy has risen from 4.9 percent to 6.7 percent of income.

Disaster relief will bring additional aggregate demand as $61 billion for Katrina disaster relief has already been approved by Congress with more to come. Payouts by insurance companies are likely to add at least another $30 billion in spending.

Disaster relief is not the only source of soaring government spending. Just before Katrina hit, Congress passed a record-breaking highway program that included $286 billion in spending with a record 6,371 specially earmarked projects. The total spending for highway construction will, in real dollars, exceed total spending for the Marshall Plan that helped to rebuild Europe after World War II.

Unit Labor Costs

Oil price inflation has gotten a lot of press recently, but unless rising oil prices can work their way into labor costs, then inflation tends to remain moderate. That has been the case over the past five years where rapidly rising productivity growth has kept a lid on labor costs and inflation. The good news on the labor-cost front may be over.

In the second quarter of 2005, unit labor costs soared after nearly three years of posting small declines. The rise in labor costs is due to a slowdown in productivity growth and soaring benefit costs. Growth in unit labor costs has actually exceeded the growth in the consumer price index, pointing to business margin pressures and higher non-oil related consumer prices in the future.

Is the Fed Behind the Curve?

It has often been said that the role of the Federal Reserve is to take away the punch bowl before the party really gets going. The Fed has traditionally done this by keeping the short-term Federal Funds rate above the rate of inflation.

Since the middle of 2002 the Fed has allowed short-term interest rates to remain below the rate of inflation. By having such an accommodative monetary policy for such an extended period of time the Fed was hoping to steer the economy past the worst economic effects of recession, accounting and financial market scandals, terrorism and war. As a result of this extended period of policy accommodation, the Fed has spent the past 18 months raising short term interest rates in hopes of getting ahead of what already appears to be an acceleration of inflation.

Impact on Business

With energy prices up sharply this year, overall inflation is already near the late-1990s peak of 4 percent. The combination of significant fiscal imbalances, a still accommodative Fed and an economy that is near full employment all point to inflation going higher. While double-digit inflation seems unlikely, inflation rates in the 5 to 7 percent range can not be ruled out before Fed policy begins to take hold. A more aggressive Fed could keep inflation under 5 percent but that scenario would probably require a recession.

With inflation headed higher, the era of cheap credit is behind us. While the risks of recession are still low, they are on the rise. The vast amount of government stimulus that is being placed into the economy coupled with higher prices for their products will push growth up in basic industries like construction, energy and manufacturing. At the same time, credit-sensitive industries like housing and general merchandise retailing will suffer.

Food prices have risen much faster then overall inflation. Traditionally when food prices rise faster then overall inflation, consumers respond by cutting back on the volume of their purchases. Food retailers will need to focus on maximizing margins in this environment as generating more unit volume will be a challenge.

Gas prices have gone through the roof, prompting a cut back in consumer demand for gasoline. While top line revenue will remain strong due to these price hikes, maintaining profitability will be a challenge as non-gas, in-store sales are likely to suffer in this environment. Maintaining cost discipline will also be important in an environment of rising wage and health costs.