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How Inflation Unravels Recoveries

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

We got Producer Price Index data this week, definitely showing signs of inflation in the market. Inflation is something that has been on a lot of investors' minds over the last few weeks.

Here with me to offer his take on the inflationary environment today is Morningstar's Bob Johnson, director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: So before we get into the nitty-gritty on some of the things you are looking at, let's talk about why inflation is such an important part of the economic cycle.

Johnson: Yes, and that's a really important thing to keep in mind, and many people don't realize it, but it's really inflation at the end of the day that ruins most economic recoveries. Almost every economic recovery that has come to an end has come to an end because inflation has outstripped wages, and therefore consumers can't spend as much. And then you start to break the demand cycle down, and since you have already had a little bit of overbuilding, things begin to collapse on themselves. So inflation, especially inflation exceeding wage growth, is really what does in most economic recoveries, and it is the single most important data piece to watch.

Stipp: Then on the flip side, when you are in the middle of a downturn, it's deflation that ultimately gets people to start spending again.

Johnson: That's absolutely what happened this time around. We had some major price decreases going on [in] the recession, and that caused people that were otherwise usually savers to say, "you know, I'm going to go out and buy that car that's 10% off of what I would usually have to pay."

So it's that phenomenon of getting people off the sideline with lower prices that got this recovery going, and [price levels are] going to be the very same thing that ends a recovery.

Stipp: So obviously this is why inflation-deflation figures are one of the main things on your radar. I know it's also part of the Fed's mandate as well to help manage inflation. But I'd like to take a step back and think about what are the arguments for inflation and deflation. It still seems like there are two camps out there. There is one camp that's saying there are a lot of headwinds against inflation that are going to keep prices lower. What's their argument, and is it still pertinent today?

Johnson: Sure, I think it is, and I think we've got to be careful not to take things to extremes. It's not either/or in terms of the camps. There is a little bit of a blend.

But the argument against inflation is that we have got a lot of slack capacity, especially labor capacity and industrial capacity here in the United States. And if we have all that extra capacity, how the heck can prices go up?

And in fact if prices on commodities, which are clearly going up--your cotton, your oil, your copper, are all clearly going up. Their argument would be, well fine, those things will go up, but as the price of gasoline goes up that means [consumers will] have to spend more on gasoline and therefore they'll cut back on their spending on something else, and that will make the price of that something else go down, and so, therefore, it's a self-correcting mechanism that you have got going there.

Stipp: So they are saying that balance will keep inflation in check.

So another thing is, some folks are saying the rampant inflation of the 1970s can't happen again for some structural reasons today. What's that argument?

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Johnson: In the 1970s, there were cost of living increases that were built into almost every labor contract, union labor contract. Labor union contracts were a much bigger percentage of the total workforce then, and frankly even some office workers had arrangements where they got a cost of living adjustment every year. So if inflation went up, big deal. I'm going to get the money back, so I am not fighting, I am not shifting my budget around.

So there was a lot of that going on in the 1970s. It's a so-called transmission mechanism for how when commodity prices and gasoline started to go up, then you saw it flow all the way through, and you didn't have this cutting back on other products happening.

Stipp: So back then it almost really fed into itself in a cycle of inflation.

Johnson: It fed into itself, and this time there are very few things that are indexed to inflation, maybe Social Security is one of the few that's left out there that's really still indexed, and that actually didn't get an adjustment this year because of the deflation a year before.

Stipp: So some structural differences between today and back then that might keep inflation in check.

On the other side of the ledger, though, you're looking at some things like CPI, and you're seeing some factors that might show that we will start to see some inflation there. What are some of the things that you're looking at that might be evidence that inflation will be heating up more than maybe some expect?

Johnson: There are lot of commodity prices, a lot of commodities that we actually use every day, and those we can't avoid. We can't in the short run really cut back our oil demand a lot, and it's a decent part of the equation, and so you're going to see that go in.

And a lot of the commodities that they are all talking about, you can't just strip them out. They are there, and the prices are trending upward, and as long as the emerging markets continue to have their little boomlet, it's going to drive up the prices of commodities, and it's going to mechanically flow through the CPI number.

And on top of it, housing has been a real help in keeping the number down. They use rent equivalent to calculate housing in the CPI number, and rents for a while weren't going up at all, and that's a big percentage of the CPI calculation.

Now, with people moving out of houses and into rental properties, rents in many markets are up and up substantially in some markets: New York and San Francisco, for example, maybe not across the whole United States. But they're creeping up, and [rent is not] going to be the tailwind that it was that kept inflation down. Now, the rent category may actually begin to accelerate a little bit, and that's going to hurt the CPI calculation, too.

And then the whole worldwide demand situation would be the third thing that I'd cite. We aren't setting the price of most commodities anymore here [in the United States]. We can have slack demand here, but if they've got strong demand in China, [producers] will just go and sell their gasoline in China instead of here, and so there are alternative [markets] to put goods into, and that's the other thing that's going to keep inflation a little bit higher than people are thinking.

Stipp: Speaking of global inflation, although it's been pretty mild here, when you start to look globally at the numbers, the inflationary environment has certainly already heated up in some areas, and that can have an effect on us here in the U.S. as well, right?

Johnson: Absolutely. You've seen some of the inflation in some of the markets, and [Tuesday] we saw the Import Price Index up 1.5% in one month, and when you start to annualize, that's a really big number ... so that's the mechanism to how it affects us.

The increases have really been quite large in several places. China, for example, was close to 5% year-over-year on the most recent inflation data, so that's a big data point. Brazil in January was up 6%, so that was a big number. Even in Europe, the number is now more like 2% instead of 1.5%, and that's a bigger number than we're dealing with right now in the United States. So, that's already starting to roll into the numbers.

In fact ... even in Germany, which is considered the ultimate inflation hawk, Volkswagen, which employs well over 100,000 people in Germany, just increased their wages for all their employees across the board by 3.2%, so that's a big number, and they just did that. So, that shows you how things are starting to work into the equation.

Stipp: So certainly, if some of these countries start to tap the breaks a little bit with the controls they have on inflation, we might see some effect on the growth of U.S. companies that have business overseas.

Johnson: Yes, absolutely. So, we just talked about the fact that if their prices are going up, and we import a lot of things from those countries, that makes our prices go up.

The other effect that you're going to have now is on GDP growth, where ... the prices have gone up in these other markets, and you really begin to have an issue with them cutting back, and raising interest rates, putting on capital controls, things to slow growth--and that means less exports out of the United States to other parts of the world, and so then it begins to cycle back into our GDP, not just inflation.

Stipp: So, as you're thinking about all these factors and looking at data like we got this week on the producer prices, what are your expectations for inflation going forward? What's going to concern you? What are your thresholds for worry?

Johnson: Well, just to put in some perspective, we're about in the 1.5% range, which is one of the lower rates. I think probably Japan is the only other country that's really even lower than that in terms of inflation.

So, we've been relatively benign on that front. But on the other hand, that rate has been accelerating on the CPI recently, and if you look at the Producer Price Index, on a year-over-year basis, that was up 3.6%. So, clearly, not everything has gotten transmitted on, so the first camp is kind of right in a way. But I think clearly the PPI numbers suggest that we've got more inflation in front of us.

Now, in terms of what I'm looking for on CPI, I'm thinking at 2% to 2.5%, and I think the Fed is thinking about 2% and the economic forecasts are generally in the 1.5% to 2% range. And that's up from the 1% to 1.5% range over the last year or two. So, we're already taking a step up there that we haven't really seen before.

Stipp: If we get much above 2.5%, do you really start to get worried?

Johnson: 2.5% is going to get little people nervous on the corners. It's going to certainly hurt bond prices, but I think if you start getting over 3% on any kind of consistent basis, then we're really going to get into trouble.

Stipp: All right Bob, well, thanks so much on the context and the importance of the inflation data and for speaking with me today.

Johnson: Great to be here.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.