With the government’s official price indicators having climbed to rates not seen in many years, some are musing that the worst of the inflation uptrend is behind us. A prominent economist suggested in the New York Times that the reported 1.2 percent increase in producer prices for July — which put the 12-month rate at nearly 10 percent, the highest since 1981 — was “old news.” He maintained that the “cure for the inflation problem is a recession in the United States and Europe.” A columnist for Barron’s, as incredible as it might seem, even spotted signs of a “deflationary riptide dragging at the U.S. economy.”
This line of reasoning is seriously flawed. The recent rollback of commodity prices and the rebound of the dollar’s forex value from record lows are providing superficial support for the notion that the inflation problem has been solved. This mode of analysis is closely tied to the proposition that economic weakness will, ipso facto, restrain inflationary pressures. Unfortunately, this also is the dominant view at the Federal Reserve, which remains content to sustain an exceptionally easy posture.
The suggestion that commodity-price declines are indicative of the anti-inflationary effects of sluggish growth doesn’t square with the fact that these prices had been rising steadily for most of the past year in the face of an economic slowdown. There’s a much clearer correlation between the Fed becoming increasingly more accommodative, the dollar weakening, and commodities ramping higher.
That said, the Fed has stayed easy over the past month alongside a notable pullback in commodity prices and a rally in the dollar. Some exogenous trading events, such as a less-hawkish-than-expected policy announcement from the European Central Bank, helped strengthen the dollar in the short-run, which in turn produced a ripple effect in the commodity markets. The steep correction in the price of gold was somewhat puzzling, although it now appears to be consolidating $50 above its recent low of $775.
Gold is the key indicator in this story. When gold topped $1,000 in the immediate wake of the Bear Stearns calamity in March, this most monetary of all commodities signaled the risks associated with an aggressive easing response from the Fed. And when the Fed decided to provide discount-window access to Wall Street investment banks — thereby sidestepping a forceful easing response — the price of gold fell back by some $150. It was a repeat performance when the Fannie/Freddie panic hit in mid-summer. Gold initially rallied to just below $1,000. And when the crisis passed without an overt easing response from the Fed, gold fell back again.
Today, considering that the Fed seems hamstrung at a very easy 2 percent funds rate for as far as the eye can see, gold in excess of $800 an ounce points unmistakably toward a sustained period of elevated inflation. The gold price has soared by nearly 30 percent over the past year and has almost doubled in the last three years. Considering the lags involved when these impulses feed through the system, historical evidence suggests that we’re now only in the early stages of upward price adjustments — that is, unless the Fed takes sufficient action to strengthen the dollar’s real purchasing power and root out the inflation now embedded in the system.
Although the dollar has appreciated by about 7 percent since mid-July, it has lost some 17 percent of its value on a trade-weighted basis over the past three years. Measured against the euro, the recent dollar rally of more than 6 percent pales against a depreciation of nearly 30 percent over the last three years (10 percent of that depreciation occurred in the past year). Viewed this way, the dollar’s recent appreciation does not alter the fact that the currency remains extremely weak and is unlikely to help curb today’s outsized inflationary pressures.
The more than $40 slide in the oil price from its peak of $150 a barrel last month will help moderate headline inflation to some extent. But this will be more an appearance of slackening inflation pressure than a reflection of the underlying inflation reality. It’s becoming increasingly clear that the inflation that first showed up in sensitive commodities such as gold and oil is spreading across the price universe. Non-energy CPI is up at an annual rate of 4.2 percent in the past three months, the highest it has been in seventeen years. The Cleveland Fed’s trimmed-mean CPI, which filters out the most volatile 16 percent of the index rather than arbitrarily excluding food and energy (as is done with the conventional core index), is also running at a seventeen-year high of 3.6 percent.
Make no mistake about it: Recent commodity-price declines and the appreciation of the dollar are welcome events. But these indicators — gold, in particular — are at levels that suggest inflation will remain elevated for the foreseeable future. In the likely event that it does, the Fed will have run out of excuses. To get inflation under control, the central bank will have to raise rates.