Now that the U.S. Federal Reserve has said it is ready to raise interest rates to head off inflation, economists are watching every indicator like hawks for signs that higher prices are becoming a problem. The verdict so far? Unfortunately, that depends on which indicators you look at. The latest gauge of the manufacturing side of the U.S. economy shows a sharp spike in commodity prices — a spike bigger than at any time since the late 1970s, in fact — but the Fed's favourite measure of consumer-level inflation is much more restrained.
In a recent research note from BMO Nesbitt Burns, senior economist Russell Sheldon (his last note, in fact, since he is retiring from BMO), pointed out that several parts of the Institute for Supply Management's survey of manufacturing activity show that prices are climbing higher due to inventory pressures. "The basic theme in the U.S. economy has swung from excess capacity to shortages," he wrote, adding that this situation is "extreme by any standards."
The problem, Mr. Sheldon says, is low inventory levels. Since many companies cut back on their production dramatically during the economic downturn of the past several years, they have little or no ability to respond to rising demand without buying new materials and increasing their output, all of which tends to push prices up. "Inventories at all stages of production plunged relative to sales," the BMO economist said. According to data from the Bureau of Economic Analysis, the ratio of inventories to sales — a measure of the number of months needed to sell existing inventory — has fallen to the 1.25 range from 1.43 in 2001 and the 1.35 level in the late 1990s.
Mr. Sheldon says that the impact of shortages in most manufacturing supplies "has become so extreme as to become a candidate for labelling as a macroeconomic shock." The vendor deliveries portion of the ISM survey, which measures how easy it is for manufacturers to get shipments of new materials, has gone from below the 50 mark in 2001 to the upper 60 range — higher than it has been since 1979. The ISM price index is in a similar state: it is close to 90, after dipping as low as the mid-30s in 2001, and according to Mr. Sheldon is also higher than it has been since 1979.
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As the BMO economist points out, the fact that the ISM price index is so high now is even more of a concern than it was in the late 1970s, since that was a high inflation environment — in other words, prices were rising rapidly for all kinds of things. The U.S. economy currently has very little inflation at all, which makes such sharp price spikes unusual. And the services side of the economy is also suffering from low deliveries and low inventories, according to recent data from the ISM.
"The spillover to services is obvious, ominous, and something the Fed has to worry about," Mr. Sheldon wrote in his research report. The U.S. economy, the BMO economist says, "has outgrown last year's conservative expectations by a mile, generating shortages and widespread price hikes that are large and will have to be passed along to consumers." Oil prices are "just the tip of the iceberg for this supply shock," he said, and if the Fed fails to respond to these kinds of signals in a serious way, "the markets will get nervous."
For the moment, however, there is a substantial gap between the prices that manufacturers are seeing and the Federal Reserve's favourite inflation indicator, which is called the "core PCE deflator." This benchmark is derived from the consumer price index, but excludes various products that make the index more volatile — food and energy — making it an indicator of "core" inflation. In April, the deflator rose by a measly 0.1 per cent, and the U.S. Commerce Department also revised its earlier figure for the rate of increase so far this year to a 1.7-per-cent annual rate from 2 per cent.
According to David Rosenberg of Merrill Lynch, the core PCE deflator has been advancing by less than 0.2 per cent per month for the past 15 months, which the Merrill chief economist says is "a feat not seen since the 1960s." In fact, Mr. Rosenberg said in a recent report that some parts of the U.S. economy are actually seeing deflation, with prices falling — including the durable goods sector and the services sector. He also points out that prices have fallen year-over-year for goods such as new cars, appliances, computer software, Internet access, furniture and photographic equipment.
In other words, the price increases that many manufacturers seem to be wrestling with (according to the ISM survey) have yet to push consumer prices up to the point where they worry the Fed. They may do so soon, however — or businesses may decide to absorb these higher costs in the interest of gaining customers or increasing market share. That in turn would have a fairly predictable effect on the stock market, since it would mean lower profits. Either of these outcomes could mean trouble.
Please check back later for the full column.