Thu, 11 Apr 2013
Morningstar's Bob Johnson explains the sources of higher prices, and what they're implying about the potential of future inflation.
Jason Stipp: I'm Jason Stipp for Morningstar. Of all the indicators he watches, inflation is one of the most critical to our director of economic analysis, Bob Johnson. He is here to explain why and to give us a read on what the current inflation indicators are saying.
Bob, thanks for joining me.
Bob Johnson: Great to be here.
Stipp: So, you say that inflation is very important to watch because of its connection to recessions. It's not necessarily a direct connection, but can you explain your thinking on recessions connected to inflation somehow?
Johnson: Absolutely. Inflation is the number-one predictor of recessions, and it's a very timely measure. It doesn't come two years in advance. The time lags between increased inflation and the recession is very close and very similar from recession to recession. There are a lot of indicators that can be relatively good. The Institute for Supply Management Manufacturing Index is once in a while good, but it signals three false readings for every positive reading, so it's got a lot of volatility. Some of the other measures are also pretty good, but sometimes they lead by two years and some times by two months, and so it doesn't do a lot of good.
Stipp: What's the mechanism that makes this such a timely notice of a potential recession?
Johnson: Yeah. Again there may be, as you alluded to, another cause of the recession, like the big housing bubble this last time around, but really we might have survived a little bit better. But what happened is we had a bout where gasoline prices and food prices went up dramatically, at the same time the housing market was beginning to fall apart. The approximate cause was actually inflation, even though the root cause was the housing situation.
Now, here is the mechanism. What happens is, consumers tend to get their wage increases once a year, if that these days, or their bonuses once a year. So, if inflation runs along at a certain percent and all of a sudden it's a lot higher, they immediately kind of have to cut back. They have to say, "Well, all right, my gasoline price is up, so I'm going to have to cut back what I'm spending somewhere else." So, they start cutting back on their spending, and then that creates less need for production, and that means you need less employment. If you employ fewer people, that means less income, and that means less spending. And so you get this vicious cycle started. Until prices actually turn around and start to go down, the vicious cycle kind of continues.
Stipp: So, what's that threshold where customers have to start cutting back right away because prices are just too high?
Johnson: It's amazing that over kind of 60 years of looking back at the data that that 4% level has been kind of magic. Again, it's year-over-year data. It's not one month annualized, and it's not actually one month over one month; it's a three-month moving average compared with a three-month moving average. Every time we've gotten over 4%, we've had a recession.
Stipp: So, let's talk about the range of expectations, since this is such an important one to keep an eye on. What are people expecting inflation to do, because we're under that 4% right now?
Johnson: Right now, the metric is running at 1.8%, which is basically half of the average. The average is something like 4.1% since 1948. The median number is at 3.1% because the numbers in the 1970s were so spiky, we got up all the way to 15%, which kind of biases the numbers just a little bit.
Stipp: So, we're underneath that right now. What are people's expectations? Are people worried we're going to get close to that 4%?
Johnson: Well, consumers are little bit more worried than the business economist. Consumers right now, according to the University of Michigan survey, think inflation a year ahead will probably run 3.3% or so, whereas kind of the Wall Street Journal poll of economists says 2.2%. You look at some of the numbers that are implied, some of the Treasury Inflation-Protected Securities and compared with Treasury securities, it also implies something closer to the 2% range than the 3% that consumers are thinking.
Stipp: So still within the safety range in general?
Johnson: All of them are in the safety range right now.
Stipp: So, what are some of the factors that could cause inflation to go higher? So, underlying, what things should we keep an eye on if we start to see some movement then we maybe start to get worried.
Johnson: Well, let me talk about the four historical things that have really moved inflation, and then what could make any of those wrong, if you will. First of all, I look at monetary policy, and there I look at money supply. I don't necessarily look at the bond-buying programs in the same way because I need it to be in the banks and out and lendable, which is kind of what's measured by M2 money supply. And that right now is running at about just over 7% growth and the long-term average of that number is 6.9% growth. We're not wildly out of line there.
The data, when you look at the charts, isn't as conclusive as one thinks. I mean, the Chicago school of monetarists would have you think that that's the only thing that moves inflation, but you look at it and it was relatively good in the 1970s and ‘80s. But we've had spikes in money supply that haven't resulted in inflation, and we've had declines in money supply that haven't resulted in deflation. So, it's kind of an odd mix. It's not as good a predictor as I would have thought, but right now it is running at the long-term average. Despite all the bond buying, it's not running wildly ahead of what we consider normal.
Stipp: So, money supply is not a big concern right now as far as driving inflation. What about your second one you say is the output of the economy? How does that factor in?
Johnson: Yeah. This is a very, very interesting one. I get the data off of the St. Louis Federal Reserve site and it's compiled by the Congressional Budget Office. And it's called the output gap. It looks at what the GDP is right now in terms of growth rates in comparison with what you would expect, given the current levels of employment, unemployment, what productivity growth is expected, capital put in place, and productivity of that capital.
So, there are quite a few things going into the calculation, and we're running at near record lows on that metric. We're running at about 94%-95% of that effective capacity, that output gap, which is, I like I say, one of the largest numbers out there. And it's very difficult to get a head of steam up on inflation with that number being as low as it is, and it's really a neat metric. It's been very, very, very effective at calling inflation.
Stipp: So that would suggest there is some slack basically that we're not utilizing right now, and if we're not utilizing it, prices will tend to stay lower?
Johnson: That's absolutely correct.
Stipp: The other one, you talked about monetary policy, is fiscal policy. The budgets and the spending and everything they're wrangling on in Congress right now. What's the impact of fiscal policy?
Johnson: Well, in some ways they aren't wrangling any more. They've lowered the axe, if you will. Fiscal policy has gotten unbelievably tight, and that's one of the reasons the Fed has been loose on monetary policies to offset that. We've basically in a couple-of-year period moved from a 10% budget deficit to a 5% budget deficit. Even though it is still a deficit as many readers might point out, it's that fall in the deficit, the rate of deficit right now that is so contractionary. We're taking kind of $300 billion out of the economy every year right now with our deficit-reduction programs. That's a big hurt to the economy, and it also tends to keep inflation way down.
For example, in the 1970s, we had monetary expansion, fiscal expansion, and commodities kind of all going up at once. It had the trifecta of really bad things. So when people say, "Well, gee, we should have bad inflation this time," I say, "Well, in the 1970s, you look back and they had a lot of special circumstances then."
Stipp: The last one seems like the big wild card as far as inflation, and that's commodity prices. These are the ones that can spike the cost at the gas pump and can really hurt consumers very quickly if we see that kind of spike. So, I think the mechanism is pretty clear. What's the commodities situation looking like and how much did actually contribute to the overall inflation rate?
Johnson: Yeah. Food is about 10% of the number and gasoline is about 5%, and you throw in other energy, you put all the food and energy together, you're probably at close to 20%. So it's a big deal, and a lot of that's now decided outside of our hands, so to speak. It's what happens in China, what happens in Europe, what happens drought-wise in Brazil, and what happens drought-wise here in the United States. So it's not necessarily easy to predict. One of the very interesting things about commodities is that they do indeed actually cause inflation. But over time, if you're spending more on those commodities, that will make the prices of other things probably go down eventually.
The output measure that I talked about earlier has had a near-perfect track record. It missed two bouts of inflation, and the one that's probably most visible that I want talk about is 2011. We had a little spike that got us almost to 4%, didn't quite get there in 2011 on inflation. And that was a commodities-driven--gasoline and food again--price increase. Well, that lasted about three to six months, and then it kind of fizzled out and went back down again.
So, what I've noticed in the charts is when you have a commodities-oriented inflation, it tends not to last as long as when it's an output-based type of price increase. So, you can still get them, you still have to worry about them, but they won't be sustained if you don't have an output gap.
Stipp: So, where are we right now with commodity prices? Have they eased off a little bit because we're starting to see a little bit of gasoline price inflation this year?
Johnson: Yeah. Interestingly, let me change gears on you a little bit, I was talking to our farm equipment analyst just this morning, Adam Fleck, and there is another USDA report out suggesting that crop inventories were a little bit higher than everybody thought, and the weather has been a little bit more favorable. The ground moisture is beginning to pick up a little bit now with some spring rains that we've had and snows. So the ground moisture is probably a little better than it was going in the last season, which is really good news.
I think corn is now under $7 a bushel. It's not quite all the way back under $6 again, which is I'd like to see, but a lot of the food prices have come in. Gasoline prices are now down from something close to $3.90 a gallon on average according to AAA, down to closer to $3.50-$3.60 a gallon. So we've really kind of come back there, too. So, good news so far, but it can always spike.
Stipp: All right. So, looking at these four, it doesn't sound like any of them are raising any red flags right now, so I assume your overall inflation expectation is pretty moderate?
Johnson: Yes. I would say we can continue in this 1.5%-2.0% range that we have been, but there are risks to that. Now, again, the numbers are 1.5%-2.0%, which is half of the long-term normal, so that has ramifications. That means interest rates should probably relatively low and it means a couple of other things, too. Gold probably isn't as great an investment; commodities might not be such a great investment in that type of noninflationary environment. So those are the ramifications.
But some of the risks to my optimistic forecast--say the North Korean situation blew up or something with Iran and oil prices spiked again--then all bets are off, and we're going to have inflation. Let's say we have another drought in the U.S. The weather pattern turns really, really dry again and crop prices go up, well, then inflation is going to go up. So those are the risks. One kind of risk that is a little bit more predictable is how tight the banks remain. We talked about the bond buying hasn't had a big impact yet because banks haven't lent the money. Their rules are too tight on lending the money out right now. If those rules were to become less tight, or for one reason or another, banks in general did become easier with their money and some of the bank bond-buying programs that have gone on will suddenly begin to creep into the system--that's another thing that I am keeping my eye on. If bank guys say that they are lending everything they can, then I am going to get scared.
Stipp: All right, Bob. Well, some very interesting research on the causes of inflation. It sounds like some pretty good news on the inflation front at least for right now, maybe some of those wild cards aside. Thanks for joining us and for those insights today.
Johnson: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.