Inflation Outlook Moderate
Despite Spike in Energy Prices
By Alan Levenson
Chief Economist
T. Rowe Price
Inflation concerns have become more prominent since political unrest in Libya - a major oil producer - raised the specter of a 1970s-style oil supply shock. Indeed, the roughly 15% increase in crude oil prices during the second half of February translates into a rise in the pump price of gasoline of a bit less than half that magnitude.
Even as oil prices show signs of stabilizing, the full impact of the late-winter runup will likely lift the retail price of a gallon of regular gasoline into a $3.75 to $4.00 range by midyear.
Yet the upward pressure on energy prices predates the fears of supply disruption related to political unrest in the Middle East and North Africa (MENA). Crude oil prices began to rise sharply in early September as better economic data dispelled fears that last spring's Greek debt crisis would spark a double-dip recession.
And oil had company in the commodities space. In the half year to mid-February, while the price of crude oil rose roughly 30%, indexes of raw industrial materials and raw food commodities prices advanced by roughly 25%.
In the past, swings in commodity prices - energy and food in particular -were driven significantly by transitory changes in supply caused, for example, by geopolitical developments or unanticipated weather patterns. More recently, however, the rise of fast-growing emerging countries in the global economy has injected a lasting increase in demand for a broad range of commodities.
The upshot is an upward shift in the degree of commodities-based inflation relative to the state of the U.S. economy.
These effects are greatest in the energy sector, where the crude input is a predominant component of the refined output. The pass-through is weaker in food production. Nonetheless, the consumer price index (CPI) for food has also accelerated in recent months, lifting the year-to-year inflation rate to 2.3% in February from -0.2% a year earlier.
As the commodity content of domestic products declines, the available capacity in a particular industry - and associated labor, distribution, and other costs - becomes a more important determinant of price pressure.
Thus, apart from food and energy - in the so-called core inflation process - margins of available slack in labor and products play a more significant role. This is particularly the case in the United States, an advanced economy in which goods make up only 40% of the consumption basket, with services composing the rest.
On this score, industrial utilization rates have been low and unemployment rates high, speaking to ample potential supply that will hold measures of underlying inflation at low levels over the next two to three years.
In terms of the direction of inflation, however, the critical factor is that margins of slack are diminishing. For example, after drifting sideways for almost a year, the unemployment rate has begun a marked decline, falling by nearly a full percentage point since November 2010.
Concurrently, manufacturing industry utilization rates, well off of their mid-2009 lows but making limited further progress after May of last year, quickened their cyclical ascent in recent months, surpassing August 2008 levels.
Finally, the rental vacancy rate, which peaked in mid-2009, began to fall sharply from the middle of last year. While still high by historical standards, the onset of a declining housing vacancy overhang signaled an upturn in rents, which gained traction in mid-2010.
As a result of these developments, the year-to-year rate of core CPI inflation (excluding food and energy) has risen from a trough of 0.6% during the final months of 2010 to 1.1% in February; we see it rising to 1.5% at the end of this year and to at least 1.75% by the end of next year.
With food and energy set for larger increases this year (2.5% and 7.0%, respectively), the overall headline CPI is set to rise by 2.3% this year and 2.5% next year.
Energy and food prices could fall back for a time, as is often the case after a sharp ascent, perhaps in response to monetary tightening and moderating growth in China or a cooling of political risks in the MENA region. If not, persistently elevated prices in these sectors could have an impact on the broader inflation outlook.
Higher energy costs could pass through to non-energy sectors that are intensive energy users, such as transportation services. In addition, particularly as labor markets tighten, higher food and energy costs could pass through more fully to wages. Because labor costs are a significant portion of total costs for most industries, this development would lead to price pressures for various industry sectors.
Finally, a weak dollar and elevated foreign inflation could boost import price inflation further, creating more leeway for domestic producers to raise prices.
None of this is to say that we are on the verge of a 1970s inflation outbreak. The Fed remains strongly committed to holding inflation near 2% over the long term, but it has been equally committed to raising inflation toward 2% in the near term.
In its willingness to allow core inflation to rise while the economy strengthens and global inflation pressures mount, the Fed may not be playing with fire. But it seems at any rate to be playing with matches.
It will be important for the Fed to start raising interest rates, beginning the gradual process of returning monetary policy to a broadly neutral setting, long before the unemployment rate approaches a level that policymakers view as being consistent with a fully employed economy.
If the Fed waits too long, misjudging the persistence of commodities-based inflation or the levels of resource utilization at which broader inflation pressures intensify, an inflation dynamic could take hold that would require a more aggressive course of tightening - with risks to the economy.
Editor's Note: Founded in 1937, Baltimore-based T. Rowe Price is a global investment management organization with $509.9 billion in assets under management as of March 31, 2011. The organization provides a broad array of mutual funds, subadvisory services, and separate account management for individual and institutional investors, retirement plans, and financial intermediaries. The organization also offers a variety of sophisticated investment planning and guidance tools. T. Rowe Price's disciplined, risk-aware investment approach focuses on diversification, style consistency, and fundamental research. For more information visit www.troweprice.com.
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