Outside of energy, certain commodities, retail inflation is not a problem

Late last week, the government reported that the closely-followed Consumer Price Index increased 0.5% in December, as a steep 4.6% rise in energy costs led the way.  Talk of higher food prices, however, have yet to materialize, as costs rose just 0.1%.

The core rate of inflation, which removes the more volatile energy and food categories, remains extremely low, rising 0.1% for the second month in a row.  For the calendar year 2009, prices increased 1.5%, while the core rate remains uncomfortably low – at least for the Fed – at 0.8% (see chart below).



Interestingly, with all the talk about higher food prices around the world, food at the retail level is up just 1.5% from one year ago and up just 1.7% on an annualized basis over the last three months.  That means we aren’t seeing much in the way of price increases at the grocery store. 

However, wholesale food prices have jumped at annualized double-digit rates in three of the past four months so increases may be on the way among grocery stores.

Nonetheless, overall inflation should remain at low levels for quite some time despite the latest round of QE by the Fed and deficit spending by the government since forces that are holding price increases at a minimum far outweigh unsettling trends that could unleash a new wave of inflation.

First, the unemployment rate remains very high, which has been putting downward pressure on wages – wages make up the largest costs for most firms.

Those who have jobs are willing to settle for tiny wage increases, substituting job security for a more robust lifestyle, and the large pool of skilled labor that is available for most industries means that businesses don’t have to bid up wages and benefits just to attract the best and the brightest.

Second, capacity utilization has rebounded but remains at an historically low level. Since manufacturers can still boost production without worrying about bottlenecks or shortages, there isn’t the concern that further gains in demand might boost prices.

In addition, all but the smallest increases in prices are difficult to implement amid fears that customers might just run into the willing arms of competitors.

Third, and an important part of the anti-inflation equation, inflation expectations remain muted, which also makes if very difficult for companies to hike prices.

Inflation brewing over the longer-term?
No doubt about it, energy costs are up and a host of increases in commodity prices are, at the margin, putting some pressure on firms.  Still, productivity gains have helped to offset rising commodity prices for most, and even if companies wanted to boost prices, the generally sluggish economy makes it difficult to do so.

Nonetheless, the huge amount of liquidity available to support economic growth, and secondarily, the rise in commodities, does provide support for the inflation argument down the road.

In order to prevent today’s disinflationary environment from morphing into an inflationary environment, the Fed will have to time its exit strategy just right, not dampening growth by doing so too soon or waiting too long and unleashing the inflation genie from the bottle.

Looking at the Fed’s historical record, it seems unlikely that it will pull the plug too soon.  More likely, the Fed will want to see a sizable drop in the unemployment rate before it embarks on a new path.