Thursday, September 3, 2009

ISM service sector indices show growth and inflation picking up

Conditions continued to improve in the service sector in August, according to the Institute for Supply Management's indices. As the top chart shows, we are not yet seeing robust conditions, but things have certainly improved from the lows of late last year. Perhaps more significantly, the prices paid component of both the manufacturing and service sectors shows strong gains in recent months. This is quite likely an indication that a) the Fed's super-accommodative monetary policy stance has not only eliminated deflation risk, but may be laying the seeds for higher inflation in the months to come, and/or b) the big decline in money velocity (i.e., cash hoarding) that caused the economy to nose-dive last year is beginning to reverse. If either or both of these forces are at work, that argues for continued, relatively strong gains in economic activity, cash flows, and inflation in the months to come.

The more we see things pick up like this without any indication from the Fed that it is going to start reversing its liquidity injections, the more nervous I get. To judge by the price of gold, which is now making yet another run at the $1000 barrier, and the dollar, which is quite weak, global investors need no encouragement to protect the purchasing power of their money.

Curiously, however, the bond market remains quite complacent about inflation, as reflected in a moderate decline in breakeven spreads in recent weeks. I've observed disconnects such as this in the past, and my intuition has usually told me to bet against the bond market when this happens. From long observation, I have become quite skeptical of the bond market's ability to correctly forecast inflation. The main reason for this is that both the bond market and the Fed (which has hero worship status for the bond market) believe that inflation happens only when the economy is "too strong." With the economy still decidedly weak, bond and Fed types conclude that inflation is impossible.


__ said...

Comment from the ISM on the prices paid reading for the mfg index: *ORE SAYS PRICES FIRMING FROM DEFLATED LEVELS, NOT INFLATING.

Scott Grannis said...

I think that is consistent with what I'm saying. Prices are moving up from where they were.

djakel said...

The bond vigilantes and the Fed are stuck on Keynesian Economics and the Phillips curve. They are always too late to recognize inflation. Bernanke won't tighten until employment starts rising. By then, inflation will really be heating up. Gold investors are paying attention.

狂猪 said...

Hi Scott,

What are your thoughts on China's impact on inflation in the US?

Today, there seem to be a number of factors in China that suggest inflation in the future is a major issue. This includes growing labor cost, growing raw material cost and growing asset bubble in Chinese real estate and Chinese stock market. Furthermore, while right now, China has stopped the appreciation of RMB relative to the US dollar because of the current crisis. However, as the crisis subsides, China will very likely allow the RMB to appreciate gradually again. All these factors together suggest there is a build up of pressure for the price of Chinese goods to rise.

Coming out of the last tech bubble, US inflation was kept in check with low cost Chinese goods. At the time, sourcing from China was relatively new and the additional cost reduction was signficant. Because of the cheap Chinese import keeping inflation in check, the Fed was able to use employ a loose monetary policy to revive the economy. Today, however, we already get a lot of manufactured goods from China. This time, there is no additional cost reduction from Chinese goods. In fact, there is a very likely cost increase.

What would happen if inflation in China takes off while the US economy is still recoverying and unemployment still high? The higher price Chinese goods will show up as inflation in the US. Will the Fed's tightening of monetary policy be affective at that point? Can the Fed tighten monetary policy if unemployment is high? This seems similar to supply push inflation of the 70's oil shock. I don't think it is as severe but I also hope we don't get stagflation.

Scott Grannis said...

The most important thing to keep in mind when talking about inflation, China and the U.S. in the same breath, is that inflation in both countries is determined primarily by the actions of the Federal Reserve. By tying its currency to the dollar, China is effectively outsourcing monetary policy to the Fed. The behavior of prices in China has virtually no impact on the general price level in the U.S.

China has been smart enough in the past to allow the yuan to appreciate against the dollar as the dollar was falling relative to other currencies and gold. That mitigates the amount of inflation that China will eventually experience as a result of inflationary Fed policy.

If the dollar continues to decline and the Chinese do not allow yuan appreciation, then inflation will rise in China a little sooner than it will in the U.S. The Chinese economy doesn't have the inflation inertia that the U.S. economy does, so the lags from monetary policy to the economy and inflation are shorter.