Prices Hit the Turning Point

China’s growth rate is recovering, and Europe is slowly pulling out of its recession. This should lead to increased energy demands and higher prices on the world market as well as higher raw material and consumer prices.

The August Consumer Price Index increased 0.1 percent, but it was also the fourth increase in as many months. Temporary swings in a few important goods offset increases elsewhere. For example, medical expenses and shelter prices rose.

But these were largely offset by energy prices that declined by 0.3 percent as gasoline, fuel oil, and natural gas prices fell, and food prices moderated as the effects of last year’s drought became history.

We have higher consumer expectations and accelerating GDP growth. In August, industrial production leaped a healthy 0.4 percent and manufacturing production an even more impressive 0.7 percent.

Overall capacity utilization rose to 77.8 percent, inching closer to the 80 percent level that begins to add inflationary pressures to the economy. Manufacturing capacity utilization rose to 76.1 percent.

The Federal Reserve has pumped sufficient money into bank reserves to potentially fuel enormous growth in the money supply. This is a necessary ingredient for broad-based price inflation.

The private sector and prices are at a turning point. A slow inflationary trajectory is starting to emerge. The only thing holding it back is the confusion on Capitol Hill.

As of this writing, the government has partially shut down because of the collapse of budget negotiations between Congress and the president.  This translates into a significant decline in government spending, at least in the short term—a major source of demand in the economy.

The longer the shutdown persists, the greater the impact on spending, GDP, and prices. As January looms, the second round of sequester cuts are set to take place, putting further drag on the economy and on inflationary pressures.

Consumer prices

Private sector growth is creating fuel for inflation. Businesses are expanding production, making incomes more likely to grow, stimulating spending, and adding upward pressure to consumer prices. We are already seeing this pressure in higher prices in a lot of goods and services outside the volatile food and energy sectors.

Shelter prices have increased three months in a row, with rents increasing 0.4 percent in August. Medical care prices rose 0.6 percent in August, with hospital services rising 1.9 percent for the single month. The prices of personal care products, usually a very stable group, rose 0.3 percent, and apparel prices rose 0.1 percent.

The upward trend is a bit hard to see because of the moderation of some highly volatile food and energy prices that have wide impact.

Overall, energy prices fell 0.3 percent in August, with the CPI gasoline index falling 0.1 percent. As with the CPI, the decline in energy prices, most importantly in gasoline prices, moderated AIER’s Everyday Price Index. It declined 0.1 percent in August.

Energy prices spiked earlier this year. The August decline represents a return to a generally rising trend. A similar process is underway as food prices turn the corner.

While there were broad increases in food prices, the prices of a few important foods have fallen to trend. This has led the total food index to increase by only 0.1 percent in August, and belies a fundamental change toward rising prices.

Most of the major grocery store food groups had price increases in August. Fruit and vegetable prices rose 1.2 percent in August after rising 1.5 percent in July. Meats, poultry, fish, and eggs rose for the third month in a row, increasing 0.6 percent. Dairy and related products prices rose 0.4 percent after falling three months in a row. Cereals and bakery products prices rose. The prices of food away from home also rose.

Wholesale prices

Inflationary pressures are also evident in producer prices, which give a hint of future consumer prices. In August, the Producer Price Index for finished goods rose 0.3 percent, seasonally adjusted. That’s 3.7 percent on an annualized basis.

Almost all of this month’s increase in finished goods prices was due to price increases in finished energy goods and finished consumer foods.

Finished (wholesale) energy prices rose 0.8 percent for the month, 10.5 percent annualized. Wholesale gasoline prices rose 2.6 percent.  We see similar price increases in foods. Finished consumer foods prices rose 0.6 percent for the month, 7.3 percent annualized, led by a 26.9 percent increase in fresh and dry vegetable prices.

Supply

Expanding production means more jobs and income, which boosts demand.

Industrial production leaped 0.4 percent in August, and manufacturing production 0.7 percent, buoyed by the news of second quarter growth of GDP of 2.5 percent and improving economic conditions here and abroad. Industrial production is now at 99.4 percent of its 2007 average.

Other measurements also reflect increasing economic activity. Overall capacity utilization rose to 77.8 percent from 77.6 percent, and manufacturing capacity utilization rose to 76.1 percent from 75.7 percent.

Economists watch these numbers, looking for them to reach the critical range of 80-85 percent. At these levels, inflation will begin to become systemic.

Surveys confirm the increase in activity. The Institute for Supply Management’s (ISM) monthly survey of supply executives—the Purchasing Managers’ Index (PMI)—suggests that new orders, production, and employment are growing in the nation’s manufacturing sector. Moreover, businesses are working off inventories to the point that supplier deliveries are starting to slow.

The August PMI came in at 55.7 percent, as compared with 55.4 percent in July. This is a new high for the year, and the third straight month of expansion.

The ISM Prices Index, which measures the prices actually paid by producers for their materials, was 54 percent, a 5 percentage point increase over July, confirming higher raw materials prices in manufacturing. Of the 18 manufacturing industries reported by ISM, 15 reported growth in August and only one industry reported contraction.

Demand

Consumer spending, formally known as personal consumption expenditure, has been declining since at least the beginning of 2012, as Chart 1 above shows. On casual observation, it would be easy to assume that the decline will continue.

But there are reasons to expect the trend to reverse, and even to believe that, in fact, it did reverse in April 2013. Chief among these are early signs that consumer expectations are positive and that the expansion of supply should help provide the income to support higher levels of consumer spending.

The Conference Board’s Consumer Confidence Index rose to 81.5 in August from 80.3 in July, suggesting overall confidence in the economy. More importantly, the Board’s Expectations Index rose to 88.7 from 86.0, suggesting that consumers expect economic conditions to improve within the next six months.

The Business Roundtable CEO Economic Outlook Survey revealed a similar outlook. The survey’s index fell slightly to 79.1 from 84.3, but is still strongly in positive territory.

In fact, this month’s index is virtually the same as the long-term average of 79.3. It seems that business outlooks have at last returned to normal.

Earlier this summer, people were already starting to worry whether consumers will be out in strength during the critical holiday season this year. Will they have the buying power to carry a strong fourth quarter?

If August is any indication, the answer is yes. Fueled by an increase in after-tax income of 0.5 percent (0.3 percent after inflation), consumers increased their spending by 0.3 percent (0.2 percent after inflation). While not dazzling, these are pretty substantial numbers.

Money

Federal Reserve policy also supports a turning point to higher inflation. It takes demand and money to create an upshift to a higher inflation rate, and abundant money is floating around the economy.

The Fed announced late September that it will continue its bond-buying programs. This ensures easy money and cheap credit, and pours money into bank reserves. As shown in Chart 2 on page 4, bank reserves are currently over 35 times the required reserves.

Normally banks hold 1 or 2 percent over their required reserves because excess reserves represent loans that were never made. Loans are the primary way that banks make their profit. They lend at interest.

So instead of 1 or 2 percent in excess reserves, they are holding 3500 percent of their reserve requirement. Also, as the table above shows, recent compounded annual rates of growth of reserves have been enormous, ranging as high as 88.2 percent. Unheard of.

This means that there is enormous potential for lending and money circulation as demand continues to recover. This represents a high risk of inflation.

Markets seem to be aware of this problem. Bond buyers have already built an increase of about 1 percentage point to interest rates into yields at all maturities, as shown in Chart 3 on page 4.

The shift in the yield curve from a year ago has occurred despite the Fed’s best efforts to prevent rising rates.

This is matched by the shift in the inflation-adjusted rates, which means that it reflects the change in the outlook for inflation by the public.

The economy is at a turning point. Higher inflation is coming as the economy recovers. All the elements are in place.