Friday, April 11, 2008

U.S. Trade Reports Show Strong Inflationary Pressures

The last two days we've been getting some statistics related to U.S. foreign trade. And they all indicate continued inflationary pressures in America.

Import prices rose a full 2.8% from the previous month and 14.8% compared to 12 months earlier. Much of this is related to soaring prices of oil and natural gas, but even excluding energy, import prices rose 0.9% and 5.0% compared to a year earlier. Still, while that is higher than in the past, the price of non-fuel imports is rising a lot less than one would expect given the decline in the dollar. That can be explained by two factors, neither of which are really sustainable and both of which indicate future lagged effects of current dollar weakness.

One is that some contracts are made on the basis of futures contracts which were written months ago, meaning that they are still trading on the basis of the exchange rates prevalent several months ago. However, when futures contracts are written today for the purpose of trade that will be made months from now, this will of course be made on the basis of current exchange rates, meaning that prices will rise months from now because of the current decline of the dollar.

The other explanation is the tendency of many export companies to absorb short-term exchange rate fluctuations in their profit margins rather than passing them on as price increases. The idea behind this strategy is that market shares are more easily lost than gained, and so if the dollar recovers it makes sense to temporarily accept lower profit margins rather than permanently losing market share. However, if the exchange rate movements turn out to be permanent, it would make more sense for these companies to sell their products in other markets where profit margins are higher, meaning they will raise export prices to countries with permanently weak currencies. As the dollar stays weak, more and more companies will interpret the weakness as permanent and pass on the price increase (Or hypothetically if the dollar recovers they will abstain from lowering prices. But in any case they will raise prices relative to the exchange rate movement).

All of this means that import prices will continue to rise significantly in coming months, even if the dollar stabilizes.

Meanwhile, export prices are also rising fast, up 1.5% from the previous month and 7.9% from 12 months earlier. The story here is roughly similar to the import price story, with the commodity price boom being the primary mover but with other prices rising fast too. Here however, it is the agricultural commodity prices rather than energy prices, as America is a large net importer of energy products while being a large net exporter of farm products.

Also, here too other prices are rising more slowly than the dollar value of other currencies for much the same reasons as in the case of non-energy imports. Note that it is not only higher import prices which will contribute to higher domestic price inflation in America. The rising export prices will have a similar effect. The reason is that as it becomes more profitable for American companies to export, they will feel much less pressure to lower prices for Americans, and more room to raise prices for Americans.

The trade report indicates that the U.S. trade deficit is in fact rising despite the weak dollar. Although this month surprisingly showed a decline from the previous month in the petroleum deficit and a rise in the non-petroleum deficit, the underlying trend is for the petroleum deficit to rise because of the rise in oil prices while the non-petroleum deficit to fall because of the increase in agricultural prices as well as the weak dollar and weak domestic demand. However, this cannot simply be explained by the commodity price movements. Even if oil prices rise and the demand for oil is relatively inelastic, this need not imply a higher trade deficit as Americans then if they were determined to increase their savings would cut back more drastically on the purchases of imported goods. However, it seems that the Fed's dramatic rate cuts have reduced the willingness to save so much that it for now overwhelms the substitution effect from the falling dollar. That may perhaps change in the future, but for now it seems that the demand-boosting effect from lower interest rates overwhelms the substitution effect of a weaker dollar. That in turn implies that domestic inflationary pressures remain in place.


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