Inflation Gyration

There has been so much talk/hype about inflation this year because it touches all of us and therefore is a story that attracts everyone. Indeed, the surest sign of price increases has been seen at the pump and at the grocery store, places we frequent weekly.

The good news is that almost all commodity prices across the board have cooled—crude oil has backed off from a high of $147 to the $114 level, down 22% in about 6 weeks and grain prices have retreated--rice is down 40% since May. Unfortunately, just as it takes time for price increases to work their way into the system, so too do decreases experience a lag effect. The Labor Department’s release of the July Producer Price Index (PPI), that is, prices that businesses pay for goods (versus what consumers pay), indicated that high prices are still with us.

PPI rose by a seasonally-adjusted 1.2% in July, marking a 9.8% from July 2007. It was the highest annual increase since June 1981. The index of core prices, which excludes food and energy to gauge underlying inflation, rose 0.7% in July for a 3.5% increase from a year earlier, its highest in 17 years. The surge does not yet account for the decline in oil prices, since the survey was taken too early in July, but given the data recently released for consumers, it is startling to note that businesses are absorbing a large portion of the price increases. Consumer prices have increased by 5.6%, compared to this 9.8% spike. The net result of the differential amounts to a squeeze on the margins of the nation’s businesses, which does not bode well for profits in the future.

One worrying fact in the stubbornly-high PPI reading was noted by Wall Street Journal columnist Mark Gongloff on August 19th: the July PPI report marks “the third consecutive month that PPI growth has hovered above 7.1%, an important threshold for investors. That level has been broached on only five occasions in the past 60 years. In each case, PPI continued to surge for several months thereafter, according to Natixis Bleichroeder technical analyst John Roque. And each time, PPI growth clocked in at double digits before cooling. This suggests inflation takes time to lose steam.”

What it does not mean is a return to the price shocks of the early or late 1970s, the last time commodity prices took off and created mayhem for the economy. Gongloff notes that “Two major ingredients are missing from the recipe that kept inflation so hot for so long in the 1970s: The Fed is more diligent, and organized labor is much less able to win higher wages. Those two factors, along with slowing global demand for commodities, should keep inflation from getting out of hand in the long term, though there may be some hair-raising numbers to come.”

That’s the good news…the bad news is that inflation, like the housing and credit crises, will take time to unwind. With investor patience hanging by a thread, the additional evidence of “more to come” is unsettling, challenging and demoralizing. Unfortunately, it is exactly where we are.