Inflation coming? Featured

2:16pm EDT May 24, 2011
Inflation coming?

As the prices at the grocery store, gas stations and elsewhere climb so do rumors of inflation and fears that it will stunt an already slow economic recovery. Bob Leggett, chief investment officer for FirstMerit Wealth Management Services, shares his insight on inflation and what today’s investors need to know.

Do rising prices indicate inflation is coming?

It is true that the prices of many goods and services are rising. Odd though it may sound, there is a difference between price increases and inflation rates. Price changes are straightforward – all you need to do is look at a price tag or a billing and see if it’s higher or lower for the identical product or service than it was for your last purchase. We define inflation as a widespread increase in price changes, with the emphasis on “widespread.”

Should we be concerned about these price increases?

Well, I don’t want to say they are not a concern. Currently, the pain of price increases is felt because the prices of what we need, like food, milk and gasoline, are rising. However, the Consumer Price Index (CPI) numbers are still low because it also includes the prices of things we want (flat screen TVs and communications devices), which are falling. The most recent CPI numbers we have seen here in the spring of 2011 show headline CPI has jumped up to a +2.7 percent rate, the highest since before the Great Recession. By summertime, rising prices for oil and other commodities could push CPI to 4 percent or more. The question is whether Ben Bernanke, the chairman of the Federal Reserve, is correct in his assessment that rising inflation is a “transitory” issue.

Do you agree with him?

Bernanke is betting on a continuation of the low inflation of the past 15 years during which CPI only grew at a 2 percent or so pace. There are numerous factors behind this trend, including globalization as free trade allowed manufacturing to shift to the low-cost producer, Internet “price discovery” where the lowest price for anything is just a few clicks away, technology-driven productivity improvements and a glut of labor and loss of labor union power. The odds are that he will be proven correct, but in our judgment, the risk that he will be wrong is higher than it has been in quite some time.

What do you monitor to assess the risk of inflation and its impact?

We are watching the current round of price increases to see if they work into sustainably higher inflation. If profit margins are threatened by higher costs, companies will try to raise prices. If they succeed, workers will try to get higher wages. Employment costs represent about 70 percent of total corporate costs in the United States so if workers succeed in forcing employers to pay them more, we will have the makings of a wage-price spiral. Our most recent experience with that was back in the 1970s-1980s.

The other risk of this round of inflation is that the high unemployment rate continues to cap wage rates. In that case, consumers will have to decide between putting food on the table, paying the rent, fueling their car or making the discretionary expenditures that drive the growth of our economy. So, if things go wrong, we might get higher inflation or we might see an “inflation tax” on consumers that raises the risk of recession.

What’s the Fed doing?

The Fed is trying something new this cycle and that is QE, which is shorthand for Quantitative Easing. The Fed wanted to stimulate the economy, but with short-term interest rates already at 0.2 percent, it couldn’t lower rates. Instead, the Fed is using QE, which basically means they create money (run the printing press) and buy securities that they hold on their balance sheet. The first QE experiment was conducted in 2008-09 and averted the collapse of the financial system. It’s hard to argue with that outcome. Although I am oversimplifying things to some extent, the target of QE2 was to get people to take on a little risk and get the economy accelerating from last year’s mid-cycle slowdown.

Is QE2 succeeding?

Perhaps too well.The Fed can’t force people to make job-creating investments in the real economy, but they can provide funds at very low interest rates that allow investors (and speculators) to buy assets. Real-world factors such as the unrest in the Middle East and rising demand from emerging economies are pushing oil prices higher, but the QE2 flood of liquidity is clearly a factor in price increases for all risk assets such as commodities, precious metals and equities.

How does this affect the economy overall?

We have consistently been in the optimistic camp with regard to the economy. A year ago, we strongly disagreed with the consensus fears of a double-dip recession. However, the headwinds against GDP growth have strengthened, including rising cyclical inflation, stubbornly high unemployment, the de-leveraging of consumers and corporations, state and local government budget cuts and the fact that the Fed must eventually reverse QE or risk igniting sustained higher inflation. Job growth is essential for the economy to return to a stronger and more sustainable rate of expansion. The net of this is that we have lowered our expectation for GDP growth in 2011 to a growth rate approaching 3 percent. The good news is that the May reading of our Recession Checklist continued to show zero indications of impending recession.

What does this mean for investing?

Don’t get too caught up by media headlines. A year ago, consensus worries about inflation were morphing into deflation fears, and now we’ve come full circle back to worrying about inflation. Remember that price changes are volatile, as differentiated from inflation cycles, which typically last for decades. Over the past 20 years, the annual CPI change has exceeded 4 percent only once. The last similar stretch of disinflation ended in 1968, yet inflation did not begin to soar for another five years. Cycles move much more quickly now, but we still think it would take at least a few years for a sea change from ebbing inflation tides to a roaring surf of high inflation. Long before that cycle can work its way through, we will begin implementing strategies to protect client portfolios and enhance returns.

Have a question about investments or investment services? Contact Bob Leggett, Chief Investment Officer, FirstMerit Wealth Management Services, at robert.leggett@firstmerit.com.