Producer price inflation on the rise

The Producer Price Index rose 0.7% in March, which comes on top of a 1.6% increase in February and a 0.8% rise in January.

April’s smaller-than-expected gain cane be traced back to a 0.2% dip in the price of food following February’s outsized gain of 3.9%. The rise in energy prices slowed from February’s 3.3% to a still uncomfortable 2.6%.



The Federal Reserve, however, remains focused on core inflation, or inflation that excludes food and energy.

The core rate last month edged up 0.3%, suggesting that higher energy and raw material prices may be starting to impact the broader prices level.

Year-over-year, producer prices, though still at heightened levels, did ease from 5.8% to 5.7%, but the core rate continued to creep higher, rising from 1.9% to 2.0%.



About the only piece of relatively good news is that the increase in prices at the earlier stages of production are relatively stable (see chart above and below).

Most members of the Fed have argued that the jump in commodity prices will have only a transitory effect on inflation, and a continued moderation in increases may bolster their case.

That may be the case, even as the Fed's aggressive policy has helped to feed commodity inflation.

Still, I’m a bit skeptical.  Though we are not seeing an ever-increasing rate of price increases, prices at this level can be very volatile and pressures have yet to abate.  And the Fed's own anecdotal data suggest that businesses are beginning to experience a degree of pricing power.



Nonetheless, it’s important to look at the other side of the equation, and powerful forces remain in place that are helping to keep retail inflation from getting out of hand.

Wages, which are the biggest cost to most businesses, are rising very slowly, and there is still plenty of slack in the economy. Moreover, a ten-year Treasury yield that has been hovering near 3.50% is not signaling an imminent outbreak in inflation.

Tomorrow, we’ll get the latest on consumer prices when the Consumer Price Index is released. A survey by Bloomberg reveals that analysts expect a 0.5% rise in the headline rate and a 0.2% increase in the core rate.

Fed policy remains extremely accommodative, but rising prices at the wholesale level are beginning to complicate matters for policymakers.

Higher gasoline prices fail to dent retail sales

Retail sales grew at a fairly healthy pace last month despite the jump in gasoline prices.

The U.S. Commerce Department reported this morning that retail sales in March increased 0.4% amid soft auto sales; however, February was revised higher.

Ex-autos, sales were up a healthy 0.8%, and excluding autos and gasoline station sales (+2.6%), which helps to eliminate the distortion in the data caused by the spike in gas prices, so-called “core sales” increased a respectable 0.6%.



As I’ve argued in the past, $100 per barrel crude is not enough to derail the economic recovery, and March’s retail numbers bear this out.

Also, same-store sales posted by individual retailers for March were solid despite a much later Easter holiday this year, indicating that modest job growth is lending support to spending.

But job growth, though improving, is not a the level where it would provide a significant boost to consumer confidence. And as the chart above shows, the rate of acceleration in sales ex-autos and gas stations is gradually trending lower.



Gasoline’s impact
Gasoline prices that are approaching $4 per gallon are unquestionably a psychological blow, and crude briefly passed $110. According to the latest EIA data, prices now average $3.79 per gallon, or $0.93 above one year ago. And for every penny the price rises, consumers spend an extra $1 billion each year per economists estimates.

Still, let’s not forget that the U.S. economy towers over $14 trillion, and stocks, which initially sold off on tensions in the Middle East and higher crude prices, have recovered, suggesting the economic recovery is intact.

I suspect that the Easter holiday will give individual retailers a lift in April.   But the summer months will provide us with a greater degree of clarity, as headwinds increase from higher gasoline prices.

Economic impact of QE2 looks limited

QE2, or the second round of the Fed’s program of quantitative easing as it is popularly called, was launched with plenty of fanfare and controversy last November, but was crafted as an insurance policy against deflation as well as a way to jump-start a sluggish recovery that had failed to create a significant number of new jobs.

Since its plan to buy an additional $600 billion in longer-term Treasuries, stocks have rallied, the economy has side-stepped a double-dip recession but inflation worries have surfaced amid soaring commodity prices.

Not surprisingly, the Fed has been content to take credit for the rally in stocks and the reinvigorated economy but not the surge in commodity prices.

Looking more closely at the data, the Fed’s actions, at best, may be having only a very limited impact on the economy as I’ll explain below.

First, let’s define quantitative easing before analyzing its effect on the economy.  Quantitative easing is a tool that a central bank uses in order to provide more liquidity, or cash, than is needed to keep short term rates at zero.

In other words, a central bank, such as the Federal Reserve or the Bank of Japan, resorts to unconventional means when conventional policies that drive short-term rates to zero fail to stimulate economic growth.



In early 2009, the Fed, in its efforts to clear the logjam in the credit markets, clarified its planned asset buys by announcing it would purchase $1.25 trillion of agency mortgage-backed securities, up to $200 billion of agency debt and $300 billion in Treasury securities by the end of the year.

How does the Fed do it? What is essentially happening is that the Fed creates cash and buys government bonds from a bond dealer.  When the Fed receives its newly purchased bond, the bond dealer receives cash, which it deposits into its bank account.

The bank now has new deposits which it can lend to businesses and consumers, after holding a small percentage in reserve.  Anything above that minimum-required reserve is called “excess reserves.”

Normally, banks minimize excess reserves because they earn nothing sitting in the vault, and a bank is in business to make a profit by paying you and I a certain return on our deposit before lending it out at a higher rate.

When late 2008 rolled around, there was absolutely nothing normal happening in the credit markets, and risk-averse banks tightened credit standards and used the extra cash to shore up balance sheets. 

As you can see from the chart above, much of the Fed’s actions in late 2008 and most of 2009 simply ended up back at the Fed in the form of these excess reserves.

A quick note: Unlike in past years the Fed began paying a very small amount, 0.25%, on excess reserves held at the Fed. That’s better than what banks can get for overnight loans on the fed funds market and better than holding it the vault. Remember, the Fed is targeting a fed funds rate at between 0 – 0.25%.

The second round of QE, or QE2, has had a similar impact, as excess reserves are up nearly $400 billion since the program was initiated (see chart above). Excess reserves now stand at almost $1.4 trillion.

What is this suggesting? Simply that banks are not lending out the extra cash to businesses or consumers and instead are holding them at the Fed in the form of excess reserves, which earn a paltry 0.25%.

 

A quick look at the second and third charts seems to confirm the newly minted Federal Reserve dollars aren’t finding their way into the real economy because lending standards remain tight and consumers, who are still reeling from the worst recession in 70 years, continue to shore up savings accounts and focus on debt.



At this point in the cycle, the Fed’s extraordinarily accommodative monetary policy does not appear to be responsible for the improvement in economic activity in recent months.

Think “liquidity trap,” where monetary policy becomes largely ineffective.

Still, the very modest uptick in consumer lending and the stabilization in commercial and industrial loans are encouraging, but we’re going to need to see a greater willingness among banks to lend before the recovery kicks into high gear.

Weekly jobless claims drift lower

Weekly jobless claims fell by 10,000 in the latest week to 382,000, which marks the sixth week in seven that jobless claims have come in under the psychologically important level of 400,000.

The 4-week moving average fell 5,750 to 389,500 and continuing claims were down 9,000 to 3.7 million.



Despite the spike in gasoline prices, the downward drift in jobless claims does suggest that the economic recovery and the modest progress we've been seeing in the labor market are continuing.

Otherwise, there’s not a whole lot to say about this week’s data.

ISM services survey shows economy expanding but pace slowed in March

The ISM survey of the br0ad-based service sector revealed that the lion’s share of the economy continues to expand, but the pace moderated from the first two months of the year.

The ISM Non-Manufacturing Index released by the Institute for Supply Management slowed from 59.7 in February to a still healthy 57.3 in March. A reading above 50 suggests the service sector is expanding.



The Business Activity/Production subcomponent took the biggest drop, falling from 66.9 in February to 59.7, but new orders, which are a good indication of future activity slipped just 0.3 points to a still strong 64.1.

It appears that some of the uncertainty earlier in the month caused by the spike in oil prices and possibly what’s going on in Japan may have played a role, however, the exports component of the survey did improve.

We're also seeing a bit of divergence from manufacturing, which continues to lead the expansion.



Next month should provide us with more clarity on the situation in Japan and how that might be impacting the U.S., but it is unlikely that the jump in crude and the situation overseas will threaten the U.S. recovery in my view.

Growth in nonfarm payrolls encouraging

But more is needed

Nonfarm payrolls jumped by 216,000 in March, including a rise of 230,000 in private-sector payrolls. Further, we saw modest upward revisions to the private sector in both January and February.

March’s 230,000 increase in private-sector jobs generated by an improving economy is the second consecutive rise north of 200,000, which is the first such back-to-back increase in five years.

Given various surveys of the employment landscape, coupled with the modest drop in weekly jobless claims, it’s safe to say that the labor market is on the mend.

Still, millions of jobs were lost in the recession and more is needed to get the labor market back on track.

Most economists believe that the economy must create at least 150,000 net new jobs each month jus to absorb new entrants into the labor force.

Of course, the recession has blunted growth in the labor force, which has contributed to the decline in the unemployment rate.

Nonetheless, the expanding and broadening economic recovery is lifting job growth and I’m cautiously optimistic that a further acceleration is on tap.

ISM manufacturing remains at healthy level but prices are a rising concern

The ISM Manufacturing Index, which is a closely-followed survey of national manufacturers, slipped from a cyclical high of 61.4 in February to a still healthy 61.2 in March, roughly in line with most analysts’ forecasts.  But the cost of raw materials remains a concern.

A reading of 50 suggests that goods producers are neither expanding nor contracting.

" The component indexes of the PMI remain at very positive levels and signal strong sector performance in the first quarter. While manufacturers are benefiting from strength in new orders and production, there is significant concern with regard to commodity prices,” Norbert Ore, chair of the Institute for Supply Management said.

“Many manufacturers indicate the prices they have to pay for inputs are rising, and there is concern about the impact of higher prices on their margins."

He states his case well. 

Prices paid jumped from an already high 82.0 in February to 85.0, signaling that manufacturers continue to grapple with the high costs of materials.   And regional surveys of the manufacturing landscape suggest firms are starting to have some success passing along higher prices.

Nonetheless, wages gains have been muted and excess slack still exists in the economy, which should limit shortages and bottlenecks and help keep core inflation under control, at least in the short term.

Meanwhile, manufacturers continue to enjoy a very robust recovery.

Production rose 2.7 points to a very strong 69.0, while a modest slowdown in new orders to a still solid 63.3 suggests that the rapid ascent in the recovery is peaking, and we may be settling into a strong but sustainable recovery in the goods-producing sector.

Overall, the manufacturing sector, which helped to pull the U.S. economy out of the worst recession in 70 years, continues to lead the expansion.