At HighTower Las Vegas, we spend a lot of time meeting with clients and getting a sense of what keeps them up at night. The usual concerns seem to focus on political dysfunction, our national debt, and whether clients will run out of money in retirement. Over the past few years, as the Fed’s money printing press has been running in high gear, we’ve begun to see a new fear dominating the list of client concerns; inflation. Many people are downright worried about an explosion in inflation. While I believe inflation could tick higher, I think fears about a full-blown inflation crisis are unwarranted.
There are two main mechanisms for explaining inflation; cost-push and demand-pull. Cost push inflation occurs when input costs rise, which causes a subsequent increase in the price of final goods. As long as input costs continue to rise, inflation will continue to be “pushed” higher. On the other hand, demand-pull inflation is caused by excess demand. If supply can’t keep up with demand, prices rise, and inflation is “pulled” higher by demand. Staying true to my mission of writing posts that my wife will read, I’m going to break this up into two posts to avoid crossing the paragraph limit she imposes on me and only focus on cost-push inflation in today’s post.
The two biggest inputs costs are labor and capital (a catch-all word for resources and funding costs). We’ve come a long way in the past five years from a labor perspective. Today’s unemployment rate of 6.7% is a far cry from the peak of 9.9%. Looking at the underemployment rate tells a similar story, as we have fallen from the peak of 17.1% to 12.6% today. While the unemployment figures are still higher than we’d like, it’s worth noting that private sector employment will likely reach a record high this month.
As the labor market tightens, wages should begin to rise, which will help to “push” inflation higher. That being said, we haven’t experienced noteworthy wage inflation for decades because technological progress has elevated productivity per worker. I fully expect this trend to continue as robotics become an even bigger part of our lives (check this out if you haven’t seen what Google recently acquired). As a result of further productivity gains, we will likely see moderate wage inflation, at best, in the years ahead.
On the flip side, resources costs look set to decline, which will put downward pressure on input prices. Why? Put simply, China’s economic rebalancing process. I’ve written about this notion before, so I won’t spend much time on it here. In a nutshell, China’s investment growth has to slow because the marginal benefit of further infrastructure development is lackluster. As growth slows, the demand for commodities will decline, which will negatively impact the price of many commodities.
China’s rebalancing process is already underway and many of the infrastructure-type commodities are feeling the weight of China’s rebalance. Iron ore is down 16.5% year-to-date, copper is off 13.1%, and the list goes on and on. Oil prices, while up for the year, will probably head south as well because of the North American energy boom. Now, a few agricultural commodities are screaming higher this year, such as coffee and hogs, but these goods have less impact on overall prices than the more economically-sensitive commodities.
From a cost of funds perspective, capital is cheap. Short-term rates are near zero and long-term rates aren’t that far from multi-decade lows. The market expects short rates to begin to rise in 2015, however, the Fed recently said that the equilibrium level for short-term rates is probably going to be lower than in the past. Long-term rates will likely rise in the years ahead, but rates aren’t expected to hit punitive levels any time soon.
Looking at the input price picture as a whole, it’s hard to make the case that inflation is going to be pushed dramatically higher in the U.S. Funding costs should remain low in historical terms. Wages could rise, but that increase may end up being completely offset by the decline in commodity prices. If wage inflation ends up being more significant than I expect, great! Our nation’s workers could use some extra cash and the market has historically done well during periods when real wages are on the rise.
In Part II we will explore the demand-pull inflation case, as well as discuss the Fed’s ability to control inflation if it occurs.