Inflation Story that Nobody Is Telling You

The vast majority of consumers see “inflation” as what we’re paying for groceries, gas, a Starbucks coffee, and electricity.

Yes, it’s true that rising prices for these necessities has been the poster child for inflation lately. But there’s much more to inflation than just forking over more at the gas station or coffeehouse.

When it comes to Europe, wage push inflation plays a crucial role.

Producers Pass the Inflation Buck

the Consumer

Producer prices are simply the costs required to produce goods and services. Naturally, when producers have to pay higher costs to produce goods, they’ll demand higher prices for the goods they’re selling. In other words, they pass their higher costs to you, the buyer.

Rising commodity prices tend to be a big reason why producers’ costs rise. More money spent in production means smaller profit margins at current prices. If a producer wants to make up for shrinking profit margins but can’t control his input costs, then he must pass on these costs in the form of higher prices. Excess money creation is what drives this type of inflation, affording higher prices.

No doubt, this is exactly why rising energy costs have been such a huge driver of the inflationary environment we’ve trudged through over the last several months.

The debate is heating up among whether this global inflationary period is coming to an end. I tend to believe it is. But, more importantly, economic growth and available credit across the globe is rolling over at the same time surging commodities have left inflation concerns on everyone’s mind.

For this reason central bank policy makers are struggling.

The cost of energy has buoyed the cost for producers, consumers, and everyone in between. But what happens when this pressure eases for a considerable stretch of time?

Inflation Is a Little Bit Different on the Other Side of the Pond

They don’t serve ice cubes in their drinks. They can drive on the left-hand side of the road. And inflation is also a little bit different in Europe. Despite this fact, inflation analysis in these respective regions often focuses on generalities and overlooks one particular difference. Let me explain…

Let’s focus only on two countries and two central banks: The Federal Reserve and the European Central Bank. If you haven’t been hiding under a rock for the last year, then you probably have some kind of idea how their respective policies vary.

The Federal Reserve has knocked off more than 3% from its benchmark interest rate in the last year. In that same time, the European Central Bank has mostly stood its ground, mixing in one rate hike of 25 basis points that brought its benchmark up to 4.25%.

And if you’ve been following my currency articles lately, you also probably know that this monetary policy discrepancy has been a boon to the euro, and a detriment to the buck. For many months, even years now, the relative performance of each currency has been primarily based upon expectations for this rate differential to change.

As you might imagine, inflation expectations play an enormous role in monetary policy expectations. Even though inflation has received plenty of attention over the last several months, many analysts have neglected an important difference between European inflation and U.S. inflation.

Now’s the time to pay closer attention.

What All the Analysts Have Missed Over the Last Few Months

In the last few weeks, commodity prices (particularly crude oil) have cracked. With that abrupt downturn also came a reprieve in inflation expectations. And that’s got many accepting the potential for a lasting shift towards even lower prices and less inflation pressure.

With that in mind, the dollar has managed to rally on two simple facts:

1. The U.S. Federal Reserve has already lopped off a considerable portion of its benchmark interest rate. So they’re now ahead of the rate-cut curve, which has helped maintain some growth in the U.S. relative to Europe.

2. The European Central Bank will be forced to bailout their deteriorating economy by cutting their benchmark interest rate.

Up until this point, the European Central Bank had a good reason to keep fighting inflation. But with commodity prices easing up, now may be the time for ECB policy makers to take action. Here’s why they’ve struggled…

Why Hasn’t the ECB Joined the Worldwide Rate Cutting Party Yet?

With many threats to global growth and concerns over several Eurozone member countries, many have been surprised the ECB has gone so long without letting up on the interest rate front. After all…

• The Federal Reserve has made several moves to lower rates
• The Bank of Canada has followed suit
• The Bank of England has gotten the ball rolling
• So has the Reserve Bank of New Zealand
• The Reserve Bank of Australia is likely next

If you’re wondering why the ECB hasn’t budged, look no further than labor unions. Simply put: Wage contracts put in place via labor unions have employees’ wages moving higher in lock-step with inflation.

There’s really no thought to profitability (the point when workers typically consider demanding higher wages). In other words, rising headline inflation fuels this wage-spiral. And this wage-spiral spurs greater headline inflation. And it continues on like this. That’s something Ben Bernanke hasn’t had to deal with.

You see, the Fed has been able to react to weakening growth by cutting interest rates. The plan: As growth moderates, or rolls over, inflation is likely to follow. But that assumption is more difficult to make when you’ve got rising wages keeping prices unnaturally high. The ECB hasn’t yet been able to make that assumption. Its interest rates remain high.
But here’s what you should expect…

When the ECB finally decides to cut rates, they will do so substantially and they will do so quickly. It will be their way of reloading. Because we know, with the labor unions continually eroding profit margins and forcing prices higher, the ECB will need some fire power for their next inflation shoot-out.

If they cut back rates now, they’ll be able to hike rates and combat inflation when the time comes again. All you need to do is be prepared to act accordingly.

Attention for investors here will be on the market financials like the banks, June 30 companies reporting and the Reserve Bank board meeting tomorrow, but we should also not take our eye off the US Federal Reserve’s interest rate decision early Wednesday morning, our time. There are also corporate reports in the US, Europe and Britain that could influence markets, while some important statistics will also be released and could influence markets, especially our jobs numbers for July on Thursday. All in all it will be another week of volatility for investors to contend with.It was a year ago this Tuesday that the RBA lifted interest rates to 6.50%; that was the start of four increases that the credit crunch later turned into at least six, or 1.50% or more on mortgage and other rates. Here we have the Reserve Bank board meeting tomorrow: no change is expected. The Fed tomorrow night, our time and the Bank of England and the European Central Bank on Thursday night, our time. After the flood of poor economic news in Australia last week, there’s a small chance of a cut here, but not much. What will be interesting is whether there’s a change in its post meeting statement to signal that an easing is in the offing. The money market has already priced in a 20% chance of an RBA cash rate cut on Tuesday and a 90% probability of a move by October, with two cuts by next February. Australian statistics due for release include the June quarter and 2007-08 financial year house price index, and job ads today, housing finance and employment and unemployment figures for July on Thursday. Unemployment could show a small rise to partly reverse the surprise jump in the number of new jobs in June. The June full year and half year profit reporting season will also start to kick off with stocks such as AXA, Seven network, News Corp and West Australian News due to report. The AMP’s Dr Shane Oliver says his group expects overall profit growth for 2007-08 to come in pretty weak at around +3%, down from +15% in the previous financial year. “The economic back drop to this reporting season is the toughest since 2000-01 as growth has slowed sharply and costs have picked up. All sectors, including resources which have been hit by rising costs, are likely to report soft results for 2007-08. “However, while the results are unlikely to be the disaster the market is currently priced for after its 30% slump from last year’s high, the focus over the next few weeks of the reporting season is likely to be on the outlook statements released by companies and these are likely to be disappointing. “While market expectations for 60% growth from resources in 2008-09 are reasonable given the latest surge in coal and iron ore prices, consensus expectations for 5 to 10% growth in the rest of the market are likely way too strong and will be revised down.” he wrote. After Friday’s shock earnings downgrade from insurer and bank, Suncorp Metway, anything is possible. Important results this week will include transport and infrastructure operator, Asciano. It’s been a constant mention as a possible victim of the credit crunch and had to abandon a stalking takeover attempt of Brambles at a big loss. Its shares have risen recently, so perhaps the company might be out of trouble. Its price has bounced from less than $3 a share to $4.15 close on Friday. The shares rose 71 cents alone last week! Media groups, News Corp, Seven Network and West Australian Newspapers all release final profit this week. Seven is stalking WAN and recently lifted its stake to over 22% in a major creep up the register. News Corp’s newspaper operations in the US and Britain will take a hit and some analysts believe its US Pay TV, film and TV business may also be hurt by indifferent performance and falling consumer spending in the recessed US economy. Tabcorp is another group of interest to report since the Victorian Government snatched its gaming licence post 2012 away from it. The company’s shares have been weak ever since and there has been talk of some corporate activity. In the US the focus will be on the Federal Reserve which is expected to leave interest rates on hold and highlight the offsetting upside risks to inflation and downside risks to growth.

The Fed last week added extra liquidity moves to help a still “fragile” financial system which will push its help out into January 2009.

Friday saw the 8th US bank to be seized and closed by regulators this year: it was only a tiddler with just over $US250 million in assets and based in Florida. 

But the news of the failure, coming on a Friday after trading ended, will worry investors again: it’s the third Friday in a row that a bank failure has been announced.

The key US regulator, the FDIC, warned four other small US banks Friday to either get new capital, stop lending in some areas, or to stop issuing credit cards. This can be a precursor to later problems as managements struggle to find new capital or income streams.

We will also get US data for pending home sales, personal spending and the Fed’s preferred measure of core inflation will also be released, while in London The Bank of England also meets to consider interest rates, as will the ECB.

Both central banks will most probably leave rates steady, although the Bank of England is under enormous pressure to ‘do something” to ease the economic pain and the slide towards recession.

Like here, the US and other major economies, rising inflation seems to be the least concern in Britain for most people these days, even with high petrol prices still cutting demand at retailers.

US corporates reporting this week and likely to influence the market are tech bellwether Cisco Systems, consumer products giant, Procter & Gamble and troubled insurer American International Group. All are due to report on Tuesday, US time.

US analysts say that even if the earnings reports are solid and bring some relief, US investors will be on edge as concerns about the impact of the credit crisis on the economy persist. 

That’s especially so after Friday’s report on Friday showed US unemployment rose to 5.7% in July, its highest rate in four years, as employers cut 51,000 non-farm payroll jobs.

That’s why the spotlight will fall on the Fed’s statement that will accompany its rate decision on interest rates early Wednesday morning, our time.

The poor jobs report, along with lower-than-expected second-quarter US economic growth figures, have helped cement views that the Fed will keep benchmark lending rates steady at 2% for several months.