Prices Continue to Rise: Only a Matter of Time Before Dollar Gets Pressured

"The Labor Department reported that prices received by producers of finished goods rose 0.3 percent last month, further blunting the prospect that the economy was veering into a vicious cycle of lower prices and lower wages known as deflation” (see NYT article here). Analysts continue to be amazed that we have not yet moved into a deflationary spiral, given the weakness in the economy.

The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.

The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.

The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.

Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.

The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.

What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.

Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.

Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.

Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!

So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.

The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.

There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.

This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.

In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.

Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.

Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.

Comments

[igggy:]

What I see is China trying to re-inflate the world with US dollars. That's not likely to work. When I buy groceries, cereal costs way less than last year. I say deflation is here already. Monthly stats may not be very reliable.

May 14 06:42 PM

[ed233:]

I think I appreciate what you are saying although I do not agree completely. If I'm reading you correctly you seem to be saying that this is a supply issue and not a lack of demand that is the primary cause of the economic failure. You might be making an argument that is somewhat moot in the sense that one could say your argument raises the issue as to what comes first the chicken or the egg. Personally, I like to see this whole mess as something more simplistic. There is always an interaction of demand and supply. Or you could say it the other way around of course. However, I think a good argument can be made by saying that the US entered into an over supply capacity situation at a time when demand became severelly restricted under increasing unemployment, lax mortgage underwriting requirements along with a sudden freezing of the fiancial system augmenting the tumbling house prices. Add to that a further restriction in business activity caused by a lack of credit. As a result you have an esculation in the unemployment and consumer confidence forceably restricting consumer credit. With credit frozen businesses either went bankrupt of severelly cut back capacity utilization using a skeleton workforce. Prices eventually will rise but capacity will remain under utilized because employers lack the will to hire until they're assured of an adequate profit by increasing capacity and re-hiring. We will I suspect by year's end face a number of shortgages across various sectors of the economy where utilization cannot or will not be ramped up. Eventually this causes a supply side inflation rather than the traditional demand increase side inflation one associates with too many dollars chasing too few goods. Production of goods will decrease while the dollars will marginally increase over time. However, the US dollar will decrease against other currencies causing imported goods to esculate thus further limiting the US consumer.US Banks will not make credit easily available for fear of risk aversion while under close scrutenty by government owned banks. So those in the greatest need namely, small buisness who would normally be the largest employer will find themselves severelly restricted by lack of credit. Thus you might see another Japan scenario in the making. LOL Looking after your money.

May 14 09:01 PM

[Moon Kil Woong:]

We have a wage drop spiral weakening the economy. The fact that it doesn't translate into price drops is thanks to Bernake and the Treasury pumping endless amounts of free cash to their banker friends. But that still doesn't stop the wage collapse.

Further complicating their brainless schemes is the fact the US gets so much overseas where their "medicine/poison" can't work its magic. This inevitably results in a weaker dollar and inflation. Thus you inevitably compound one illness with yet another illness on top of it. Good going guys.

By the way, stagflation is not really better than a fischer cycle.

And if you want to help the economy you must stop being an accountant focusing on prices and preventing them from dropping but be an economist and focus on jobs and wages. For those who say Bernake, Paulson, and Geithner have saved us and done the right thing I say "bollocks".

May 14 10:39 PM

[Mistrofan:]

Moon - with all due respect (because I like your view points a lot) - what people do NOT realize here in North America (and for that matter worldwide) what would have been the implications of a Great Depression 2.0 (without the help of Bernanke and Paulson). I have to say first that I HATE interventionsim. But, that being said, this time is way too bad (I choose carefully the verb time) - as a matter of fact it is so bad that US would have suffered not only an economic great recession/depression but more important would have suffered a POLITICAL Great Depression 1.0!!! Due to market interventionsim there are voice (more of the far right) that the governemnt is going too far and this is a socialist union and so forth... I do prefer these voices. Why? Because I personally lived in COMMUNISM 23 years of my life. And, I am sorry to say it - the North Americans have NO idea how that can be. My point - a Great Depression 2.0 would have create chaos and imense unrest in North America. I am convinced that the new Communism era would have started here. That is why was necessary to be done what was done.


On May 14 10:39 PM Moon Kil Woong wrote:

> We have a wage drop spiral weakening the economy. The fact that it
> doesn't translate into price drops is thanks to Bernake and the Treasury
> pumping endless amounts of free cash to their banker friends. But
> that still doesn't stop the wage collapse.
>
> Further complicating their brainless schemes is the fact the US gets
> so much overseas where their "medicine/poison" can't work its magic.
> This inevitably results in a weaker dollar and inflation. Thus you
> inevitably compound one illness with yet another illness on top of
> it. Good going guys.
>
> By the way, stagflation is not really better than a fischer cycle.
>
>
> And if you want to help the economy you must stop being an accountant
> focusing on prices and preventing them from dropping but be an economist
> and focus on jobs and wages. For those who say Bernake, Paulson,
> and Geithner have saved us and done the right thing I say "bollocks".

May 15 12:36 AM

[IronMeteor:]

I have no problem with the story, but the conclusion is suspect. If US rates are up big and get to 500 BPS over the Euro Zone, there is no way the dollar weakens on that. Who the heck will pay that carry. This is real money, not fantasyland.

This scenario played out in 78-85, please go read the history books and really look at those charts. Huge fiscal deficits with tight monetary policy is an FX traders dream come true. Maybe not for Iceland, but yes for the UK, US, Euro zone, Japan.

It means a roaring or decent economy and a huge carry for me if I am long. Loose monetary policy is not my dream, especially coupled with huge deficits.

I guess we will see, I can accept the story might come some day, but I know when the fed starts to move, I am going long the dollar big time. Go ahead and pay the 5K carry every year on a 1K lot. Its your money. After 5 yrs, you will be broke I don't care what the dollar does.

May 15 01:17 AM

[DONE_SONZ:]

Inflation or debt default.Which is worse?What a pickle.

May 15 06:46 AM

[Candor7:]

Misotran,

Your point is well taken about the political depression 1.0 you mentioned.However the jury is out on results of interventionism
by our government. If they can retreat from their interventive stanz,
then we will gradually evolve towards a more regulated finance system like Canada has, hopefully. But i fthe government becomes entrenched in our finance and production systems, we will no longer have making profit as the most significant motive in business.
The government will impose ideologically based corporate goals which will prevent our institutions foom functioning as creators of wealth, to being distributors of wealth as dictated by government. And then we will have the politically induced depression you mention., i.e. ommunism in short, of an American brand based in "fairness" imposed on a reluctant yet peaceful public who do not yet realize what is truly happening. That impositon could become increasingly totalitarian.

So far the government has made it very difficult for TARP recipients to buy their way out. That is not a good sign. As well the government yesterday presumed to dictate who will sit on Bank of America's Board of Directors. It may be that Political Depression 1.0 is already happening unless the "givernment" reigns itself in
from micromanaging corporations illegally, and without any power basis except the carrot of money/repayment, and the threat of public defamation. This has yet to play itself out fully. In any event, the unrest of which you speak may now be unavoidable.Americans sense this, which is why equities such as Ruger and Smith and Wesson have increased in value.

On May 15 12:36 AM Mistrofan wrote:

> Moon - with all due respect (because I like your view points a lot)
> - what people do NOT realize here in North America (and for that
> matter worldwide) what would have been the implications of a Great
> Depression 2.0 (without the help of Bernanke and Paulson). I have
> to say first that I HATE interventionsim. But, that being said, this
> time is way too bad (I choose carefully the verb time) - as a matter
> of fact it is so bad that US would have suffered not only an economic
> great recession/depression but more important would have suffered
> a POLITICAL Great Depression 1.0!!! Due to market interventionsim
> there are voice (more of the far right) that the governemnt is going
> too far and this is a socialist union and so forth... I do prefer
> these voices. Why? Because I personally lived in COMMUNISM 23 years
> of my life. And, I am sorry to say it - the North Americans have
> NO idea how that can be. My point - a Great Depression 2.0 would
> have create chaos and imense unrest in North America. I am convinced
> that the new Communism era would have started here. That is why was
> necessary to be done what was done.

May 15 08:36 AM

[Jimbo:]

I have read several convincing articles that "real" unemployment is north of 15% when you factor in underemployed and discouraged job seekers who have given up. But the author seems to be saying that the unemployment rate is 80%. I hope this is a typo or my obtuseness. The author also seems to be describing a situation that I have frequently called "stagflation". This is a condition where prices go up but wages and employment stall out, at best. The result, as noted by another poster, is a decline in real living standards. Where I live, groceries, gasoline, utilities, taxes, personal services(e.g. haircuts, accountants charges) and "fees" are increasing. But my retirement income is static. I fear this is happening nationwide.

May 15 09:50 AM