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PHILLY FED SURVEY SHOWS STRENGTH, INFLATION TRENDS

Feb. 22, 2011 2:59 PM ETSPY
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The Philly Fed survey is quite strong. The highlight of this survey is about pricing power and inflation risk.

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, increased from 19.3 in January to 35.9 this month. This is the highest reading since January 2004. The demand for manufactured goods is showing continued strength: Although the new orders index was virtually unchanged in February, it has increased over the past six months. The shipments index also improved markedly, increasing 22 points. Firms also reported a rise in unfilled orders and longer delivery times this month.

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Firms’ responses continue to indicate improving labor market conditions. The current employment index increased 6 points. More than twice as many firms re‐ ported a longer workweek (23 percent) than reported a shorter one (10 percent).

Price increases for inputs as well as firms’ own manufactured goods were more widespread again this month. Sixty‐seven percent of the firms reported higher prices for inputs, compared with 54 percent in the previous month. The prices paid index, which in‐creased 13 points in February, has now increased 55 points over the past five months.

On balance, firms also reported a rise in prices for their own manufactured goods. The prices received index increased 4 points and has steadily increased over the past four months. Twenty‐nine percent of firms reported higher prices for their own goods this month, compared to 26 percent in January.

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This part is the most interesting of the survey. For background, Dave Altig
Senior vice president and research director at the Atlanta Fed, wrote on February 11, responding to criticisms that Fed executives are disconnected from the real world (my emphasis):

We recognize that the data are, by definition, yesterday’s news, and extrapolating to the future is imperfect (to say the least). For exactly that reason, we do rely—heavily, in fact—on those “consumers and executives” with whom we are purportedly disconnected. In the two weeks prior to every Federal Open Market Committee (FOMC) meeting, we meet face to face with the 44 business leaders (consumers and executives, all) that make up the boards of directors of our main office and the five branches of the Sixth Federal Reserve District. In these meetings we lay out our view of the data, how we are interpreting the information, and what we think it means for the course of the economy going forward. And then we ask them where and how we are getting it wrong.

Advice-seeking is not confined to those 44 directors, however. Our branch system is the basis of what we call our Regional Economic Information Network, or REIN. Through REIN, between each and every FOMC meeting we reach out to literally hundreds of contacts throughout Alabama, Georgia, Florida, Louisiana, Mississippi, and Tennessee. The goal of these interactions is exactly the same as with our directors: Ask real people, making real decisions, about the real circumstances as they see them. And they we ask them what they see coming, share our views on that question, and try to reconcile the two when they differ.

Every Federal Reserve Bank has its own procedures for bringing anecdotal and real-time color and nuance to the data. But we are all doing it one way or another. The picture of a Federal Reserve as disconnected from the on-the-ground realities is simply false.

And what have we been hearing? Yes, certainly highly visible prices and costs have been rising. Yes, some businesses have been able to pass these costs through to customers. Yes, there is some concern about whether price pressures might become more widespread.

But have they yet? Does it seem, as people contemplate market circumstances and their own pricing plans, that widespread price increases are imminent, or even highly probable? The consistent answer we have been getting is no.

And here is the result of the special question in Philly Fed survey:

In this month’s special questions, firms were asked about pricing of their products since the beginning of the year and their expectations for price changes in the near future. Since the beginning of the year, 57 percent of the responding firms indicated some increase in prices for their own goods, with the most frequently cited range of increase between 3 and 4 percent.

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The weighted average price increase since the beginning of the year is 2.1%. Expected increases over the next 3 months total 2.2% (weighted average). If the 38% of the firms that have not raised prices so far hiked them by 1.5%, the overall price increase would be 2.7%.

Fifty-six percent of firms have been able to raise prices early in 2011. Fifty-nine percent expect to raise prices over the next 3 months. Obviously, many more companies are seeing enough pricing power to hike prices twice within 6 months. Core inflation has clearly bottomed. Although David Rosenberg wears different lenses:

That said, the special question in the Philly Fed was all about pricing power and about 60% of respondents claim they have held or will hold their price increases to 2% or lower since the start of the year, and a similar share said they intend to follow the same restraint in the next three months. Only around one-fifth plan to raise prices by 5% or more and two-thirds said they were not experiencing shortages of raw material of any kind. So we expect an inflation hiccup in coming months, but not a cycle.

How fast will core inflation be in 2011?

The answer to that will be critical for equity markets. Rising core inflation would negatively impact PE ratios (see The Rule of 20). Continued subdued core inflation will likely negatively impact corporate profits through a margin squeeze as David Rosenberg likes to emphasize:

We saw more evidence that companies are facing an intense profit margin
squeeze with the recent macro data. The chart below is the spread between Philly Fed prices paid (input costs) and received (prices charged). The last time the spread was at 46.2 was in June 1979 … that was not a good foreboding: the four-quarter EPS trend swung from +21% to -9% a year later. The producer price index data told the same story on margins — the ratio of PPI at the crude stage to PPI at the final gate just broke above 1.3x … there were only three other episodes where this ratio was above 1.3 … in each case, EPS growth slowed substantially all three times in the next year.

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Full Philly Fed release

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