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U.S. Inflation Prospects

Economics / Inflation May 26, 2010 - 02:00 AM GMT

By: Hans_Wagner

Economics

Best Financial Markets Analysis ArticleInflation in the United States is extremely low with the GDP deflator coming in at 0.4 percent and the Core Consumer Price Index measuring 1.1 percent year over year. For April 2010, the last month reported, the CPI declined 0.1 percent.


The Federal Open Market Committee (FOMC) is keeping short-term fed funds rates in the 0.00 to 0.25 percent range. When coupled with the huge economic stimulus from the Fed and the government, many analysts expect inflation to raise its ugly head in the near future. Let’s examine the prospects for inflation and what is keeping inflation rates low for the foreseeable future.

Consumer Prices

The Consumer Price Index (CPI) is comprised of three important categories, wages, productivity and the price of commodities. Compensation is by far the largest component. Offsetting wage increases are the productivity improvements companies achieve in the production of a good or service. Improvements in productivity lower the cost of the good or service, requiring less labor and materials. Commodity prices are the third and most volatile component of the CPI.

According to the Bureau of Labor Statistics, total compensation costs for civilian workers rose 1.7 percent for the year ended March 2010. When you factor in productivity, unit labor costs (the labor cost per unit of output) have fallen 3.7 percent over the past year.

Global competition for labor has kept a lid on rising labor costs and it will continue to do so for years to come. Competition for jobs remains fierce with five unemployed workers competing for every job opening.

Elance.com, a web site for freelancers has grown to more than 700,000 members as people look for work in new and different ways. You can bid on a job, competing with talent from anywhere in the world, often for less than the minimum wage. Finding work that pays well remains a difficult challenge.

High unemployment, now at 9.9 percent and underemployment at 17.0 percent, increases the competition for jobs, helping to keep the level of inflation low.

Commodity prices are more volatility moving up and down regularly. With the recent fall in commodity prices and the rise in the U.S. dollar inflation from rising commodities is not likely.

With unit labor costs at relative low levels and commodities at recent lows, inflation from rising consumer prices is a long ways off.

Monitor changes in labor costs per unit of output to determine when inflation might pick up. Should commodity prices start to trend up expect some pick up in inflation particularly for sectors that are heavily commodity dependent.

Monetization of Sovereign Debt

Governments around the world are using substantial amounts of debt to help their economies recover and to fund social programs. Central banks are supporting this new debt with easy monetary policies. Many fear this will cause the money supply to expand at unprecedented rates. When the money supply expands faster than the GDP of the country, it leads to inflation.

Banks create new money when they make a loan. As long as lending grows at the pace of the economy, the growth of the money supply is not inflationary. The Federal Reserve can encourage or discourage lending through their monetary policies, primarily through short-term fed funds rates.

The quantitative easing by the Federal Reserve to avoid a depression has brought the government into the direct creation of money. In the U.S. the Federal Reserve buys government and mortgage bonds. When they do, it creates a bank loan by the government. This is new money just like when a bank makes a loan. The Fed carried out this new strategy to try to prevent a depression.

This massive creation of money by the Fed is what concerns many analysts, who fear the U.S. is on the verge of a new inflationary spiral.

The same concern holds for Europe as the European Union and the Central Bank are following the Federal Reserve’s example.

So far, the rapid growth in the money supply that many analysts expect has not happened, as bank loan growth remains weak.

M1 has grown 6.8 percent over the last 12-months, 3.1 percent in the last 6 months and 5 percent for the latest 3-month period. With inflation running at 2 percent and GDP growth at 3 percent, a 5 percent growth in M1 is just fine (3 + 2 = 5)

M2 a broader measure of the money supply grew 1.6 percent in the last 12 months, a -0.2 percent for the latest 6-month period and -0.3 percent for the last 3 months. The weakness in M2 reflects the outright decline in commercial and industrial, known as C&I loans, at all reporting commercial banks in the U.S.

According to the Federal Reserve data, C&I loans fell13.4 percent annually in the first quarter of 2009. The second quarter of 2009 experienced a decline of 16.5 percent followed by 26.2 percent in the third quarter and 23.8% in the fourth quarter of 2009. the trend continues as C&I loans fell another 20.6 percent annually in the first quarter of 2010. No wonder the money supply is declining despite all the money the Fed is injecting into the economy.

Europe is following the example set by the U.S., injecting almost $1 trillion in loan guarantees and grants from the European Union countries and the ECB is buying bonds to add liquidity to the markets. They are following the example set by the Federal Reserve. To see if this program will cause inflation monitor the lending by the European banks, especially commercial and industrial loans. If the European C&I loans keep falling, it is likely the money supply will not expand as some predict.

The question going forward for everyone is can the central banks reverse the quantitative easing once bank lending picks up. As a first step in their reversing process, the Federal Reserve stopped buying mortgages at the end of March 2010. In the months and years ahead, we need to watch carefully if the Fed can turn back their quantitative easing without causing the money supply to take off. Monitor changes in bank lending, especially the C&I loans to get an idea of when the Fed will tighten further.

With the prospect for inflation rather muted for now, the question becomes how  will governments pay for their huge deficits. Politically difficult spending cuts and higher taxes are in the cards. If governments are unable to address their deficits, their people face series economic consequences including deflation, the topic for next week’s Point of Interest.

The Bottom Line

To see if inflation becomes a problem monitor the changes in C&I lending, as well as the next moves by the Fed on reversing their easy money policy. Changes in the overnight fed funds rate is only one of their tools. The St. Louis Federal Reserve with their FRED database provides many useful charts and tables.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2010 Hans Wagner

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.


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