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– November 14, 2013

We are moving toward an economy with expanding production, higher incomes, and improving consumer sentiment. Food and energy prices are stabilizing. But the recent data also shows that growing demand fueled by generous money creation has begun to lead to steadily rising price inflation in core goods and services.

The energy index rose 0.8 percent in September, and dominated the numbers. This is a marked change from the last 12 months, when the prices of energy commodities like gasoline and fuel oil fell over 7 percent, while nearly everything else went up in price.

The prices of services are also rising across the board, up 0.2 percent for September, and 2.4 percent year-to-year. In particular, medical care services rose 0.3 percent in September, after rising 0.7 percent in August and 3.1 percent year-to-year.

It takes money and demand to bid up prices. In their most recent meeting, the Federal Reserve decided to continue its expansionary policy, ensuring that a growing amount of money will be there.

With the United States and world economies continuing to recover, demand is on the rise, spurring broad increases in industrial production. This has led to increases in employment, wages, and capacity utilization. Finally, import prices are rising even in the face of a stronger dollar, giving businesses at all levels more leeway to raise domestic prices.

RETAIL PRICES

Carbon-based energy products continue to be a primary driver of the prices of a wide array of consumer goods, and energy prices were uniformly pointing upward in September.

The energy index rose 0.8 percent in the month of September, accounting for about half of the seasonally adjusted 0.2 percent increase in the CPI. The 0.9 percent one-month increase in the prices of energy commodities is a striking reversal of the 7 percent decline in the prices of these commodities over the last year.

Gasoline prices in particular rose 0.8 percent in September after declining 7.5 percent over the last 12 months, and the fuel oil index rose 0.9 percent after increasing 1.2 percent in August.

In contrast to energy commodities, energy services prices have faced upward price pressure all year, rising 0.8 percent in September and 3.7 percent over the last 12 months. Among these services, electricity prices rose 0.5 percent for the month and 3.2 percent for the year, while piped utility gas rose 1.8 percent for the month and 5.3 percent for the year.

The other half of the monthly increase in the CPI did not come from food prices, as has been the case in recent months. Food prices were unchanged, after rising for three months straight. Good crop results led to falling prices for fruits, vegetables, and nonalcoholic beverages that offset price increases elsewhere.

The rest of the CPI increase came from the rising prices of new vehicles, up 0.2 percent; airline fares, up 0.5 percent; and non-energy related services, up 0.2 percent. Medical care and transportation services accounted for most of the service price increase.

WHOLESALE PRICES

Prices at the consumer level are bubbling up from price increases at the wholesale level, with energy prices as the primary factor.

As a whole, finished goods prices declined 0.1 percent in September as a result of the 1 percent decline in finished consumer foods. But looking past the serendipity in food prices, the index for finished energy goods and the index for finished goods less foods and energy moved up 0.5 percent and 0.1 percent, respectively.

Energy prices also rose at the intermediate goods level—by 0 .3 percent in September. This was the fifth monthly increase in a row, led by diesel fuel prices, up 2.9 percent, and jet fuel prices, up 3.6 percent.

The biggest increases in wholesale prices were at the crude materials level. The Producer Price Index for crude materials for further processing rose 0.5 percent in September, driven primarily by a 3.3 percent increase in crude oil prices. As with retail prices, most of this monthly increase came from prices for energy commodities, which rose 2 percent.

Crude energy prices have been on the rise for a while. From June to September, prices for crude energy materials rose 3.3 percent after rising 7.9 percent in the three months ended in June. In particular, natural gas and coal prices were on the rise.

Absent international political trauma, the current projections are for relative stability in crude oil prices, but slowly rising refining costs. This should lead to steadier prices at the consumer level for petroleum products including gasoline.

As with energy, the stability in food prices at the consumer level is also coming up from the wholesale level. Besides affecting retail food prices directly, good crops led to a short-term decline in commodity food prices, as the index for crude foodstuffs and feedstuffs fell 0.4 percent in September. Specifically, the September monthly decline was primarily the result of a 13.1 percent drop in corn prices.

The net effect is that as food and energy prices stabilize at both the wholesale and retail levels, we should see less noise in prices. But with rising demand from a recovering economy, we should see more price inflation arising from core goods.

SUPPLY

The economy is recovering. Firms are producing goods in response to demand and are paying increased wages to do it. The expansion of production is a good sign in many ways. But when combined with high money growth, it invariably leads to inflation.

In September the Index of Industrial Production rose 0.6 percent, following an increase of 0.4 percent in August. This yields a third quarter output increase of 2.3 percent annualized, and provides a hint of what the preliminary third quarter GDP numbers may look like when they are released in early November. A strong GDP showing would support an outlook of higher prices and would raise consumers’ spirits, paving the way to a strong fourth quarter and a respectable holiday retail season.

The output of utilities rose 4.4 percent in September—the first increase in six months. This kind of shift often confirms a new expansion in industrial output as firms increase their demand on utilities as they increase production. In fact, the utilities index for September was equal to its 2007 average, and was up 3.2 percent from a year ago.

The capacity utilization rate rose 0.4 percentage points to 78.3 percent, just 1.9 percentage points below its long-run (1972-2012) average. We would expect to see accelerating price inflation as this rate approaches and then exceeds the 80 percent mark.

As shown in the table below, production growth rates have shifted dramatically over the last three months, a shift not limited to a few market groups.

In particular, consumer goods production increased 0.8 percent in September, coming back from a 0.8 percent decline in July and a lackluster increase of 0.3 in August. Outside of construction, this seems to be the pattern. The quarter started on weakness, turned the corner in August, and expanded explosively in September.

Durable consumer goods production expanded 0.7 percent in September, while the production of nondurables rose 0.9 percent. The output of clothing increased 1.6 percent, rising 4.5 percent above its September 2012 level.

Businesses are not only producing, they are also buying. All major categories of business equipment advanced in September, up 1.2 percent in total, up 3.7 percent from a year ago. The production of construction supplies also continued its expansion, growing a healthy 0.6 percent in September, a 4.8 percent annualized rate for the third quarter.

In short, business activity is expanding. Businesses are producing, buying, and paying more in wages. Consumers are taking those paychecks with renewed optimism and are buying, too. The private sector has begun its upward spiral. With a financial sector flush with cash, the usual outcome is accelerating price inflation.

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