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.

Retail sales post sixth-straight rise

Consumer sentiment slips

Retail sales for December did not quite measure up to expectations, but the sixth-straight monthly increase indicates that the improving economy continues to support spending.

Sales grew a respectable 0.6% last month, which comes on top of a 0.8% gain in November.  Ex-autos, sales were up 0.5% in December following an impressive 1.0% the previous month.  Removing gasoline and autos, so-called core sales rose 0.4% after increasing 0.6% in November.

Overall, the gains over the final two months of the year indicate a fairly upbeat 2010 holiday shopping season, though the smaller rise in December may indicate that bargain-conscious consumers were drawn into the malls by early deals offered prior to Black Friday.

 

Still, the rise suggests a resilience among consumers, especially given that unemployment remains high, job creation has been relatively anemic, and housing prices have been flat or declining.

Now that the Bush tax cuts have been extended for another couple of years and Congress has gone along with the president’s proposal for a temporary two percentage-point reduction in the social security payroll tax, consumers will have extra cash to fuel additional gains this year.



In the meantime, early data from the University of Michigan’s consumer sentiment survey show that confidence unexpectedly dipped in January, dropping from 74.5 in December to 72.7.

One year inflation expectations rose, mostly due to higher gasoline prices, but inflation expectations remain well-anchored going out five years. 

That’s good news since the Fed shows no signs of delaying or easing up on their planned purchases of $600 billion in government securities.



Though disappointing, the dip is not that worrisome as the overall upward trend coming out of the summer slowdown remains intact.

Seasonal factors may be responsible for the jump in weekly jobless claims

The drop in weekly initial jobless claims, which fell to a 2 1/2-year low of 391,000 two weeks ago, has come to a screeching halt, according to the latest data.

The Department of Labor reported today that weekly claims increased 35,000 to 445,000, while the 4-week moving average gained 5,500 to 416,500.

The rise we’ve seen over the past two weeks would normally be troubling, but according to Bloomberg News, special factors contributed to the rise.

“The Labor Department believes the week's surge reflects administrative backlog built up during the shortened weeks of the holidays. They also note that many claimants postponed filing until the New Year, a move that will increase their benefits.”

Although the government attempts to account for seasonality around the holidays, unforeseen factors can sometimes muddy the data, and the Labor Department’s explanation seems reasonable.

Last year, however, similar explanations were given during the first weeks of 2010, and when claims remained at elevated levels in February, nasty winter weather was cited.  Eventually, it became clear that growth in the economy was not accelerating, and stubbornly high jobless claims were not due to an special factors.

This time around, similar trends are bear watching, and we should know soon enough whether quirks surrounding Christmas and New Years were the reason for the jump.

Still, given an improvement in most data, with the exception of housing which will remain a drag on growth, a downward drift in jobless claims is probably the most likely path during the current quarter.

Bernanke sees evidence of a self-sustaining recovery

But expect slow progress on the job front

Fed Chairman Ben Bernanke, in his written testimony before the Senate Budget Committe, said he sees "increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold."

Bernanke pointed to a 2-1/2 percent rise in real consumer spending in Q3 and evidence that Q4 expanded at a faster pace.  He also said business investment in new equipment and software has grown robustly in recent quarters, as firms have started to replace aging equipment and make investments that had been delayed during the downturn.

However, he noted that housing remains depressed amid the "overhang of vacant houses."

Stubbornly high unemployment
Despite his belief that growth will likely be "moderately stronger in 2011 than it was in 2010," an improvement in the labor market could lag.

"After the loss of nearly 8-1/2 million jobs in 2008 and 2009, private payrolls expanded at an average of only about 100,000 per month in 2010 - a pace barely enough to accommodate the normal increase in the labor force and, therefore, insufficient to materially reduce the unemployment rate."

Furthermore, Bernanke forecasts that the unemployment rate may only dip to about "8% two years from now...and it could take four to five more years for the job market to fully normalize."

And the shortfall in job creation has to be the number one problem facing the economy today.  After a sluggish start to the recovery in the second half of 2009, the economy hit a soft patch last summer that was tied to the financial instability caused by the debt crisis in Europe.

We've managed to avoid a double-dip recession in the U.S., while spending is picking up, we're seeing a broadening of the recovery, the Leading Index is pointing to further gains, and jobless claims are in a downward trend.

Still, housing is hugging the bottom and the lack of a more robust recovery has yet to force the hand of hiring managers across the country.  Until GDP begins to consistently grow at a faster pace - somewhere between 4-5%, we're not going to see much progress on the labor front.

Fiscal insanity
In the meantime, Bernanke did not shy away from the need to talk about the nation's fiscal imbalances.

He said the current path is "unsustainable," and if government deficits grow as projected by the Congressional Budget Office, "the economic and financial effects would be severe."

So far, few in Congress have seriously talked about the president's panel that has provided a blueprint for credible deficit reduction. Waiting for a crisis to sneak up and create havoc cannot be the only option.

Weekly jobless claims jump in latest week

But downward trend intact

Weekly initial jobless claims jumped 18,000 in the latest week to 409,000, while the 4-week moving average, which eliminates much of the week-to-week volatility, slipped 3,500 to 410,750.

This week’s increase shouldn’t be taken as a sign that progress in the labor market is being stifled, in my view, as the numbers tend to gyrate every seven days.  More importantly, as the chart below reflects, along with the drop in the 4-week moving average, the gradual reduction in the number of initial claims is continuing.



An accurate picture of jobless claims can sometimes be difficult to capture at year-end because of the difficulty in accounting for seasonal discrepancies, i.e., we tend to get plenty of noise in the data.

The large drop last week, followed by a fairly decent increase this week, seems to bear this out, though the Labor Department said there weren’t any special factors to consider, according to Bloomberg News.

We will get a clearer picture in the coming weeks, as January’s numbers provide a post-holiday look at claims, but recent progress suggests the recovery is broadening and is helping to strengthen what so far has been a weak labor market.

ISM non-Manufacturing Index shows recovery is broadening and accelerating

We’ve had a string of solid reports out in the last week, including a drop in weekly jobless claims, gains in manufacturing and retail sales, and today, a report by ADP that the private sector created nearly 300,000 new jobs last month (see ADP report shows huge jump in employment).

But the good news on the employment front is also being shared by a very respectable increase in the ISM non-Manufacturing Index from 55.0 in November to 57.1 in December. A reading of 50 suggests the service sector is neither expanding nor contracting.



December’s gain is the fourth consecutive monthly increase, indicating that the economy is shrugging off the slowdown experienced during the summer.  Further, key subcomponents, new orders and production, posed sizable increases, foreshadowing additional gains during the first quarter of this year.

A couple of notable items, however, the employment index slipped from 52.7 to 50.5, while prices paid continues  to put modest pressure on profit margins.

Employment in focus
Attention is quickly shifting to Friday’s labor report. Despite the very encouraging data from ADP, we’ll need confirmation on Friday when the government is expected to show that employers added 140,000 new positions, per Bloomberg.

That’s up from a lackluster 39,000 in November, which came on the heals of a solid ADP report.  But after the outsized increase from ADP, many investors will be looking for another upside surprise, as government's number carries more weight when it comes to trends in job growth.

Jobless claims are in a downward trend and the number today suggests we may finally be entering a more self-sustaining phase for what so far has been a rather weak recovery.

If we get confirmation on Friday that the ADP figure was not a fluke, we may finally start to see a level of job creation that is needed to make a dent in an unemployment rate that stands near 10%.

ISM shows manufacturing moving along at decent pace

The Institute for Supply Management reported that the ISM Manufacturing Index increased from 56.6 in November to 57.0 in December.

Though just below expectations and not nearly as robust as the more volatile Chicago PMI, today’s number shows that manufacturing continues to expand at a healthy clip and impressive gains in production and new orders suggest further improvement early next year.



In its press release, the ISM noted, "The recovery centered on strength in autos, metals, food, machinery, computers and electronics, while those industries tied primarily to housing continue to struggle.

“Additionally, manufacturers that export have benefitted from both global demand and the weaker dollar. December's strong readings in new orders and production, combined with positive comments from the panel, should create momentum as we go into the first quarter of 2011."

Manufacturing has been and continues to be a bright spot in a tepid recovery that began in the middle of 2009.  The service sector, which makes up the bulk of economic activity, has lagged as the chart below indicates, though the sector has been expanding for about a year.  Wednesday’s release is expected to show another increase.



Recently, the bulk of economic indicators suggest that growth is accelerating, including today’s manufacturing report, a dip in weekly jobless claims below 400,000, recent gains in the Leading Economic Index and the strengthening stock market.

In addition, the just-extended Bush tax cuts, coupled with a partial payroll tax holiday, should aid the economy in the coming months.