Wednesday, February 3, 2021

Inflation Is Up for Discussion


Inflation I: Prices Paid vs Prices Received

In recent Zoom calls with accounts, I am spending more time discussing the outlook for inflation. For investors, this may very well be among the most important, if not the most important, issue to get right in 2021 and beyond. If inflation looks likely to remain subdued, then we can “keep walking because there is nothing to see here, folks.” If inflation looks likely to make a modest comeback, then overweighting inflation hedges in portfolios would make sense. In recent months, there has certainly been some comeback-like action in the prices of assets that might benefit from higher inflation. If inflation were to make a big comeback, bond yields would soar. That could cause a credit crunch, a recession, and a bear market. I am inclined to keep walking.

Nevertheless, by popular demand, I will be returning on a regular basis to see what I can see on the inflation front.

I am counting on four deflationary forces to keep a lid on inflation. They are D├ętente (a.k.a. Globalization), Disruption (a.k.a. Technological Disruption), Demography (as in aging populations), and Debt (as in too much propping up zombie companies). I discussed the “4Ds” in my 2020 Fed Watching book (here is the excerpt). These forces are on one side of the tug of war over inflation. On the other side are the world’s economic policymakers. They’ve responded to the Great Virus Crisis with massive fiscal and monetary stimulus. In other words, they embraced Modern Monetary Theory. They certainly haven’t let this crisis go to waste! Let’s see what we can see in the latest price indicators:

(1) Regional prices. Five of the 12 Fed district banks conduct monthly business surveys. In addition to compiling business activity indexes, all five report prices-paid and prices-received indexes (Fig. 1). All 10 price indexes have recovered from their early-pandemic lows a year ago through January of this year. The average of the five regional prices-paid indexes is up from last year’s low of -3.6 during April to 48.4 during January, the highest since July 2018 (Fig. 2). The average of the prices-received indexes rose from -9.4 to 21.1 over this same period.

The prices-paid indexes tend to be more volatile than the prices-received indexes. That’s because the former tend to be correlated with the inflation rate of the intermediate goods Producer Price Index, or PPI (on a y/y basis), while the latter tend to be correlated with the inflation rate for the goods Consumer Price Index, or CPI (Fig. 3 and Fig. 4). Intermediate goods producer prices tend to be more volatile than consumer goods prices because they are more highly correlated with commodity prices. The spread between the averages of the regional prices-paid and prices-received indexes is highly correlated with the spread between the inflation rates of the intermediate goods PPI and the goods CPI (Fig. 5).

So what do we see? Since the start of the data in 2005, the regional price indexes have been this high before at least four times. Over that same period, the core PCED (personal consumption expenditures deflator), which is the Fed’s preferred measure of consumer price inflation, hovered just above 2.0% from 2005 through most of 2008, and has remained below 2.0% from 2009 through 2020 every month with the exception of only 14 months.

(2) M-PMI prices. January’s national survey of purchasing managers in manufacturing was released on Monday. This M-PMI survey also includes a price index, but only for prices paid. It is highly correlated with the average of the regional prices-paid indexes (Fig. 6). The M-PMI prices-paid index rebounded from last year’s low of 35.3 during April to 82.1 last month, the highest reading since April 2011. Again, this index is more reflective of commodity-related costs at the intermediate PPI level than consumer goods prices. It has been this high before a few times since 2005 without leading to a pickup in CPI inflation.

Inflation II: Commodity Prices, the Dollar, and Import Prices

The latest M-PMI report included a long list of rising commodity prices with only one down, for caustic soda. Commodities in short supply included copper, corrugated boxes, electrical components, electronic components, semiconductors, and steel. All of these are included in the intermediate goods PPI.

The core intermediate goods PPI tends to be more closely correlated with the CRB raw industrials spot price index (Fig. 7). A broader measure is the CRB all commodities price index, which includes energy and food commodities (Fig. 8). Both CRB indexes have rebounded significantly since early last year, with y/y gains of 13.7% for the broader index and 16.8% for the raw materials index.

Some of this strength in commodity prices is attributable to the 3.4% y/y drop in the trade-weighted dollar (Fig. 9). The weak dollar has certainly contributed to the rebound in the inflation rate of the nonpetroleum import price index from last year’s low of -1.1% during April to 1.8% during December. In turn, rising import prices are putting upward pressure on the intermediate goods PPI (Fig. 10).

So what do we see? The rebound in commodity prices is partly attributable to the weaker dollar, but the rebound in global economic activity has also boosted these prices. In any event, while the weak dollar and strong commodity prices are boosting import prices and the intermediate goods PPI, there’s no sign that those cost pressures are boosting consumer prices.

Inflation III: CPI Inflation Here & Over There

The core CPI inflation rate in the US was only 1.6% y/y during December. The comparable measures for the Eurozone and Japan were close to zero at 0.2% and -0.5% (Fig. 11). Over the same period, the headline CPI inflation rate in China was 0.2%, while the industrial products PPI was -0.4% (Fig. 12). We are startled by the latter given that China’s economic recovery since early last year has been so strong.

So what do we see? The same as you can see: not much inflation for consumer price inflation in the US and around the world. The rebound in commodity prices, import prices, intermediate PPI prices, and prices paid could put some upward pressure on consumer prices in the US. However, the 4Ds still have a lot of pull in the tug of war over inflation.

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