Inflation and Cost Pressures under Control

Many people are worried about a jump in inflation, but I expect the forces that are currently constraining price increases to continue to do so.

Recently, pressures for higher inflation have been fairly strong. Most inflation measures finally reached or topped the Federal Reserve’s target of 2% over 12 months.

Businesses are reporting cost pressures in both quarterly earnings reports and in the surveys by the Fed’s regional banks. For example, Coca-Cola took the unusual step of increasing prices during the year, primarily because of higher material costs.

Wage growth is much higher than it was only a few years ago. Commodity prices also are much higher and seem likely to continue rising.

If this were a normal economic cycle, everyone at the Fed would be worried that price increases were about to mushroom, but there are other forces at work currently.

Normally, at this point in the economic cycle, inflation would be much higher. A primary reason inflation isn’t higher is that wage increases are still modest by historic standards.

With unemployment low and the economic recovery having continued for so long, wage increases should be much higher than they are. While wage increases should be expected to rise, they aren’t likely to reach the levels typical of the late phase of the economic cycle. Technology, global competition and the overhang from the financial crisis will continue to restrain wage increases.

Those factors also have held down inflation rates on goods for some time now. If the trade conflicts escalate, that might change. For now, technology, global competition and other factors are keeping prices from rising much.

There also were one-time events that caused inflation to rise over the last 12 months, but which are fading now. For example, the introduction of new cell phone pricing plans about 18 months ago caused a sharp drop in the average price of plans. Cell phones have a surprisingly high weight in the Consumer Price Index.

Fiscal and monetary policies also should restrain inflation over the next year. The Fed has been tightening monetary policy since 2015, and that has raised concerns about the potential for a recession in 2019 or 2020.

While there are no warning signs of an imminent recession, the Fed’s policies have started to have effects on the economy and markets. The potential for lower growth should limit price increases.

Fiscal policy, especially the tax cuts, has helped offset some of the Fed’s tighter policies by boosting growth. The effects of the tax cuts should be winding down in late 2018 and early 2019. That would mean slower growth and less pressure on prices.

The strong dollar and economic weakness outside the United States are additional forces that limit pressure for higher prices.

Overall, inflation isn’t likely to be a significant problem for a while. The greatest risk is that Fed officials won’t see the forces that are keeping a lid on inflation and will tighten monetary policy too much.

The Data

Housing data was weak this month. New home sales declined 5.3% for the month and are up only 2.4% over 12 months. The sales decline came despite a 2.5% fall in median home prices over the month, and a 4.2% drop over 12 months. Analysts attribute the weakness to higher mortgage rates and a shortage of skilled labor and materials.

Existing home sales also were weak. They declined 0.6% for the month and are down 2.2% over 12 months. Higher prices might be a reason for lower sales. The median sale price rose 4.5% for the month and 5.2% over 12 months.

The FHFA House Price Index increased only 0.2% for the month. That amounts to a 6.4% increase over 12 months.

The latest reading from the Richmond Fed Manufacturing Index came in at 20. That’s a slight decline because last month’s Index was revised higher to 21 from 20, but it  indicates that growth continues in the region.

Durable Goods Orders are reflecting the improved manufacturing climate that we’ve seen in the Fed regional bank surveys. The headline number showed a 1.0% increase in orders for the month, and last month’s number was revised higher from negative 0.6% to negative 0.3%. More importantly, core capital goods orders rose 0.6%, and last month’s number was revised higher from a negative 0.2% to a positive 0.7%. Core capital goods are basic business investment, and an increase shows businesses are investing for higher growth.

The PMI Composite Mid-Month Flash Index also indicates that solid growth continued. The composite declined to 55.9 from 56.0. The manufacturing component increased to 55.5 from 54.6, while the services component declined to 56.2 from 565. Overall, conditions haven’t changed much, and growth is widespread.

New unemployment claims increased by 9,000 for a total of 217,000. The four-week average is 218,000. Again, all unemployment claims numbers are near historic lows.

The Markets

The S&P 500 returned 1.05% for the week ended with Wednesday’s close. The Dow Jones Industrial Average rose 0.92%. The Russell 2000 declined 0.29%. The All-Country World Index increased 1.37%, while emerging market equities jumped 2.62%.

Long-term treasuries lost 1.65% for the week. Investment-grade bonds fell 0.10%. Treasury Inflation-Protected Securities (TIPS) declined 0.50%. High-yield bonds increased 0.36%.

On the currency front, the dollar fell 0.88%. The dollar had been on the rise in recent months, so its valuation will be worth watching closely in the weeks ahead.

Energy-based commodities increased 2.60% in the past week, while broader-based commodities surged 2.91%. Gold rose 0.42%.

Bob’s News & Updates

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