By:Lou BrienCommodity prices have been on a run since the end of August. Coincidentally the rise began just as Fed boss Bernanke shouted from the mountain top in Jackson Hole, Wyoming that QE2 was on the way. Well, maybe the coincidence is just in the mind of Bernanke. Although part of the justification for the second helping of quantitative easing is to raise the level of inflation closer to two percent, give or take, the Fed Chairman told the House Budget Committee that the commodity rally is “largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply.” I don’t intend to quibble over the cause of the higher prices, there is likely a bit of truth in all of the arguments; the Fed, demand and weather related crop shortfalls, not to mention geo-politics. To the degree that the Fed is behind the move, the bid could dry up when the end of the ultra-easy monetary policy is in sight. The other factors do not lend themselves to such a simple calculus. But the point I want to discuss is the ability of businesses here in the US to pass along their increased costs to the consumer. To be sure the attempt will be made, however will it be sustainable and therefore set the stage for an extended inflationary episode, or will price hikes merely reduce demand and cause the economy to slow as a result.
The potential for inflation has become a widespread concern. Those who are critical of the Fed’s policy stance have evoked the Weimar Republic and the Republic of Zimbabwe as examples of a possible endgame for this supposedly mistaken strategy. Seriously?! Let’s try doing this sober. How about a comparison to the seventies, not quite so dramatic but more to the point considering that it was energy and food that led the way down the inflationary path back then and are again key factors today. But I think there are important differences between then and now that will make for very different outcomes.
One thing to remember as we start off is that the Fed’s favored inflation measure is the PCE Core. And even after two years of the funds rate bumping up against zero, one QE program under the belt and another one underway and with an unprecedented amount of fiscal stimulus, the latest reading of this inflation measure is 0.7%, the lowest level ever recorded in its fifty year history. As of now, the pricing power of American businesses is an aspiration, not a widespread reality. Evidence of that was presented in the latest report of the Philly Fed Business Activity Index. The spread between the Prices Paid and the Prices Received components has never been as wide as it is now. The input costs are not yet being passed along, but instead the larger fixed cost of employee wages has been kept under control and that has been the key to expanding corporate margins, not pricing power, not yet anyway.
For the period from January 1971 through December 1980 the headline Consumer Price Index averaged 7.9%, it was on the rise throughout that decade; it peaked out in March 1980 at 14.8%. Energy was one of the important drivers of the index; for instance the price of gasoline at the pump more than tripled during that time, the result of the OPEC oil embargo early in the decade and the Iran crisis near the end. Grain prices were also in a strong bull market most of the time back then. The PCE Core was not yet the focus of the Fed, but I will note that the deletion of energy and food from the calculation did not prevent this measure of inflation from a massive increase during those years; the ten year average almost tripled and finished the decade at 6.4%. This shows that pricing power was not a particularly big problem for businesses, and that is a key point for this comparison of eras.
Not to imply that the inflation of the seventies was a cake walk for the consumer, but consumers of that day could afford higher prices then in a way that they cannot now. Wage escalator clauses, a cost of living increase based on the prevailing level of inflation, were built into many of the post World War II pay packages, particularly the union deals. Such was the power of this clause that during a decade in which the CPI average was almost eight percent the real median income for that time frame showed an increase of two percent. For comparison sake in the last ten years the CPI has averaged 2.4%, but the real median income as of the end of 2009 was about five percent lower than it was ten years earlier. Wage escalator clauses became past tense during the eighties, in large part because strong unions were also in rapid decline. The unionized workforce now is half of what it was at the end of the seventies and those that remain are a mere shadow of their former selves, see the auto industry and Wisconsin teachers for example. For example, according to the Bureau of Labor Statistics, “Average annual major work stoppages have continued to decline by decade. From 2001-2010, there were approximately 17 major work stoppages on average per year, compared with 34 per year from 1991-2000, 69 from 1981-1990, and 269 from 1971-1980. Total days idle from major work stoppages from 2001-2010 have also decline over 90 percent from 1971-1980.” The point is that from the early eighties forward labor negotiations shifted from focusing on wage increases to bargaining for wage concession in exchange for job security; a strategy that was the result of less union leverage in conjunction with more competition from overseas production, both by foreign entities and domestic companies seeking to reduce the cost of their payrolls. This dynamic has taken its toll on the perception of the future for households, says the University of Michigan Survey of Consumers; “Given the virtual stagnation of wage gains, more households anticipated a falling inflation-adjusted income in 2011 than when the inflation rate was nearly three-times as high in 1980.”
So, because of these trends the advantage has fallen to the company, in sharp contrast to the seventies. The Unit Labor Costs (ULC) in 1980 was +10.9%, and for the decade ending that year the ULC average was +6.8%. But in the last two years the ULC was down 1.6% and -1.5% and the average for the latest decade was +0.8%. Employee costs were such in the seventies that business had to pass along their costs, or go out of business. Now, however, business has cut the cost of production; a combination of improved technology and a relative decline in their wage costs. In recent years they have not passed on the cost of their inputs because they have made up the difference through a smaller workforce, more temporary workers who don’t get benefits and slower wage gains overall. Of course this also depletes the ability of households to afford to pay more for goods and services, certainly they are not capable in the manner that they could in the seventies. Which makes me think that any attempt at broad price increases will be met with less demand and that could be a problem for the economy in the months and quarters up ahead, and not likely a sustainable period of high inflation. It seems to me that today we have a case of, “inflation, who can afford it” and back in the seventies it was “inflation, we’ll negotiate away its effect”.
This brings me back to Bernanke. Let’s imagine for a minute that the rally in commodities coinciding with the Fed’s QE2 announcement is more than happenstance. Higher input costs mean that companies must figure out how to maintain margins in an environment that may not be conducive to price hikes commensurate with increased commodity costs. If so then it could be that companies will continue to delay hiring in order to keep profits up. And if that is the case an unintended consequence of QE2 is a subpar labor market, when the opposite was the Fed’s professed desired outcome.
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