Tuesday, June 16, 2009

A Long Way to Inflation

Most of the media seem to have interpreted today’s lower-than-expected increase in the producer price index as good news. I’m not so sure. If you were worried that 5% inflation was just around the corner, then naturally you will have felt relief. Personally, I was more worried about deflation, and I still am. The inflation risk, if it exists at all, is in the distant future, and you could even argue that deflation in the short run increases the risk of high inflation in the long run. It’s hard for me to see how falling prices today are good news at all. And prices – excluding food and energy – did fall in May according to the PPI.

You might worry about energy and commodity prices feeding through to the broader price level. I’m worried about that too, but not in the way you might think. Undoubtedly some of that feed-through is already happening, and it hasn’t been enough to keep core producer price growth on the positive side of zero. I’m worried about what happens when commodity prices (1) stop rising (which they must do eventually) and/or (2) start falling again (which they may well do if the recent increases have been driven largely by unsustainable forces such as stockpiling by China). If core prices are already falling, and only energy prices are keeping the overall PPI inflation rate positive, what happens when energy prices stop rising?

What worries me particularly is that about 70% of the costs of production go to labor, and the forces of deflation work very slowly in the labor market. The data that are coming out today are only the tip of the iceberg. We’re already seeing evidence of the loss of upward inertia in compensation. Wage growth is decelerating, and, based on all historical experience, the deceleration is likely to continue – in this case, to continue to the point where it becomes deflationary.

I’m not talking about what will happen in the next 6 months; I’m talking about what will happen over the next 5 years. “Green shoots” – however green they may be – do not presage an imminent end to deflationary wage pressure. And they certainly don’t presage the beginning of inflationary wage pressure. Consider everything that has to happen before the wage pressure reverses and becomes inflationary:
  1. Output must stabilize.

  2. Output must start growing.

  3. Output must grow faster than trend productivity.

  4. Firms must slow layoffs to the normal rate.

  5. Firms must remobilize slack full-time employees (workers who are still on the full-time payroll but aren’t being asked to produce much, because businesses have been trying to reduce inventories).

  6. Firms must bring part-time employees back to full time. (This recession in particular has been characterized by the tendency to reduce hours rather than laying off employees.)

  7. Hiring (which has been falling rapidly) must stabilize.

  8. Hiring must rise to the point where it equals the normal rate of layoffs, to get total employment to start rising.

  9. Hiring must become rapid enough that employment starts to grow faster than the population.

  10. Hiring must become rapid enough that employment growth is faster than the sum of the population growth & labor force re-entry. In other words, net hiring has to be fast enough to absorb all the workers who will start looking for jobs again once there are more jobs around to look for.

  11. The unemployment rate must start declining.

  12. The unemployment rate must decline by 4 or more percentage points, which, by historical experience, will take a matter of years.

  13. Firms must start competing for labor.

  14. Firms must start raising wages.

  15. Firms must raise wages faster than trend productivity growth.

Maybe – just maybe – we have already reached step 1. Step 2 may be just around the corner. There is no evidence thus far that we are approaching step 3. As for steps 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, and 15......that show may come to town eventually, but...I don’t see much need to start reserving tickets in advance.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


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