Inflation dilemma (revised)
The April 2006 CPI figures were released this morning and it has sent Wall Street reeling. Perhaps the 3.5% (annual rate) increase was above market expectations. That would likely lead investors to believe that the Fed will continue to raise interest rates to keep inflation in check.
Looking more closely at the figures we see that much of the increase is due to energy price spikes. But even the "core" as they call it, all items less food and energy, rose 2.3%.
A micro view:
Who all is really that surprised? In fact in this environment I would have bet against Wall Street that the expectations should be higher. It must be kept in mind that energy is an input into the production and delivery of many goods. As production costs are higher then prices should eventually be higher.
For several months we might have expected that firms have been able to eat some of the cost increases, that is keep prices steady and reduce profits. But at some point that ought to give. Firms will find it imparative to raise prices and will be certain rivals will follow rather than not (for those who know the "kinked demand curve" story, the point of tacit collusion has been racheted up). And they should be able to get away with raising prices because we should all be expecting higher prices.
a macro view:
Now, this inflation is most likely a "cost push" rather than a "demand pull" inflation. Demand pull is the usual type where money is easy and interest rates are low. Households and businesses spend and as firms reach their production capacity (in the short run) they have too many dollars chasing two few goods. The standard remedy is to raise interest rates to cool off spending and it takes the heat off rising prices.
Cost push inflation, however, is where firms face higher input costs. As these costs rise faster than wages (I would think there is significant lag these days) then people will have their limited dollars chasing higher priced goods. People will sooner or later have to start buying fewer goods. This can provoke the "stagflation" problem: rising prices and falling spending. Fed policy is in a bind. If they are hawks on inflation then further increases in interest rates will further cool off spending. But if they want to make sure employment levels are maintained, they will have to forget inflation and keep interest rates steady.
Ok Jack, but there is no recession. Ooops. Well, maybe it just hasn't happened yet. I'm not wanting one. Furthermore, we've experienced high fuel prices before. We know we can adjust. Regardless, as long as people continue to buy the same quantities of goods regardless of the price, we can have inflation with full employment. Unfortunately this adjustment mechanism has been notoriously sloppy in past episodes (oil shocks of the 70s, a little in early 90s). On the otherhand, the economy is more adept at processing information these days.
Anyway, I'm not at all surprised by today's news and I'm just not convinced that this is typical inflation. Furthermore, we don't know that energy prices will stay so high. If pump prices follow crude oil prices, then let's keep in mind that commodity prices can fluctuate. They are prone to speculative run ups. Those who are betting that prices will rise will further drive prices higher. At some point they will believe these prices to be unsustainable and will bet that the prices will fall. Crude prices could fall to $60 in a matter of days if the stage is set right.
I'm just talking out my ass folks. If I'm so smart I'd be rich. I'm not placing bets on anything. I'm a wuss.
J
P.S. See Colin's comment on today (5/17/06)
Looking more closely at the figures we see that much of the increase is due to energy price spikes. But even the "core" as they call it, all items less food and energy, rose 2.3%.
A micro view:
Who all is really that surprised? In fact in this environment I would have bet against Wall Street that the expectations should be higher. It must be kept in mind that energy is an input into the production and delivery of many goods. As production costs are higher then prices should eventually be higher.
For several months we might have expected that firms have been able to eat some of the cost increases, that is keep prices steady and reduce profits. But at some point that ought to give. Firms will find it imparative to raise prices and will be certain rivals will follow rather than not (for those who know the "kinked demand curve" story, the point of tacit collusion has been racheted up). And they should be able to get away with raising prices because we should all be expecting higher prices.
a macro view:
Now, this inflation is most likely a "cost push" rather than a "demand pull" inflation. Demand pull is the usual type where money is easy and interest rates are low. Households and businesses spend and as firms reach their production capacity (in the short run) they have too many dollars chasing two few goods. The standard remedy is to raise interest rates to cool off spending and it takes the heat off rising prices.
Cost push inflation, however, is where firms face higher input costs. As these costs rise faster than wages (I would think there is significant lag these days) then people will have their limited dollars chasing higher priced goods. People will sooner or later have to start buying fewer goods. This can provoke the "stagflation" problem: rising prices and falling spending. Fed policy is in a bind. If they are hawks on inflation then further increases in interest rates will further cool off spending. But if they want to make sure employment levels are maintained, they will have to forget inflation and keep interest rates steady.
Ok Jack, but there is no recession. Ooops. Well, maybe it just hasn't happened yet. I'm not wanting one. Furthermore, we've experienced high fuel prices before. We know we can adjust. Regardless, as long as people continue to buy the same quantities of goods regardless of the price, we can have inflation with full employment. Unfortunately this adjustment mechanism has been notoriously sloppy in past episodes (oil shocks of the 70s, a little in early 90s). On the otherhand, the economy is more adept at processing information these days.
Anyway, I'm not at all surprised by today's news and I'm just not convinced that this is typical inflation. Furthermore, we don't know that energy prices will stay so high. If pump prices follow crude oil prices, then let's keep in mind that commodity prices can fluctuate. They are prone to speculative run ups. Those who are betting that prices will rise will further drive prices higher. At some point they will believe these prices to be unsustainable and will bet that the prices will fall. Crude prices could fall to $60 in a matter of days if the stage is set right.
I'm just talking out my ass folks. If I'm so smart I'd be rich. I'm not placing bets on anything. I'm a wuss.
J
P.S. See Colin's comment on today (5/17/06)
posted by Atomic Kid at 7:21 PM
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