Wednesday, September 26, 2007

The Inflation Time Bomb

I have a few times recently predicted that year over year consumer price inflation in the U.S. would rise to more than 4% by November or maybe even October. Given the fact that official inflation was just 2% in August, you might wonder why such a dramatic increase will occur in a mere 2 to 3 months. The reason is that the year over year rate is held down by the dramatic decline in energy prices between August and November last year. The result is that overall CPI was actually 1% lower in November 2006 than August 2006. So, the CPI in August 2007 was 3% higher than in November 2006, an annualized increase of 4%. So, all it takes for the CPI to increase 4% over the previous year, is for the CPI to increase 1% in the coming 3 months, or 0.3% to 0.4% per month-which it will easily do given the surge in commodity prices and the falling dollar.

Moreover, the effect will grow progressively larger as time goes. As you probably know from daily experience, retail goods prices are usually fairly stable compared to the highly volatile prices of things traded on financial markets, such as stocks, bonds, currencies and commodities. Most producers and retailers are reluctant to raise prices for their customers on account of what might be just temporary fluctuations in their input costs, and so the initial effect on consumer prices are much smaller than the long term effect if input costs stay high.

It is for example well documented that import prices usually don't rise initially as much as one would expect after the domestic currency falls. This is because exporters in other countries fear that they might loose market share if they raise prices immediately to compensate for exchange rate movements. And they fear that if the currency movements revert they might have trouble regaining that market share even if they again cut prices. So they prefer to absorb the falling exchange rate of the country they export too by reducing their margins-if it is only a temporary movement. This absorption might be permanent too even if the exchange rate movement proves to be permanent, but usually companies will find it more profitable in the long run to restore their margins. This means that there will be a lagged effect on import prices some time after the currency movements. This in this case means that there will be a lagged effect in 2008 on import price inflation from today’s dollar decline.

A similar logic also goes for commodity prices. There is likely to be a lagged effect on inflation from the commodity price rally. The effect will be strongest and appear first in higher energy prices and food prices. However, after some time, so-called core prices usually rise too, as I documented in my post "Does "core" inflation predict all-items inflation?".

Note that the surge in commodity prices and the elimination of last year's energy price decline from the base will push up consumer price inflation in most other countries as well. The euro area inflation rate will for example easily rise to 2.5% or so -from just 1.7% in August- later this year. However, the effect in most countries will be much smaller because they have much stronger currencies. This means first of all that the increase in commodity prices in their currencies are much smaller and also that they don't have the same general upward pressure on import prices -and export prices, which helps bid up domestic prices- as America do.


Blogger gurlate said...

that thesis is interesting..4% however would unsettle FED and i haven't heard any US economist forecasting higher inflation by yr end..
this would interferw w/ rate cut as well.

4:36 AM  

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