Michael Evans
2/5/2006, 12:58 AM
The consensus wisdom is that inflation has recently taken a turn for the worse. Not only did the CPI rise 3.4% in 2005, up from 3.3% in 2004 and an average of 2.0% the previous three years, but wage rates and unit labor costs have also started to accelerate. Last year, hourly compensation (according to the BLS productivity release) rose 5.2%, compared to 4.5% in 2004 and an average of 3.8% the previous three years. At the same time, productivity growth slackened slightly, so unit labor costs rose 2.4%, compared to 1.1% in 2004 and an average of only 0.3% over the previous three years. In equilibrium, the growth in unit labor costs equals the true underlying rate of inflation, and since the Fed has set 2% as the upper limit of tolerable inflation, this means more tightening, slower growth, and so on.
It's true that the so-called core rate of inflation -- excluding food and energy -- has hardly budged in recent years, rising 2.2% in both 2005 and 2004, comapred to 2.0% the previous three years. But this is beginning to have a hollow ring. Economic statisticians took food and energy prices out of the core calculation in order to omit the wild monthly fluctuations that sometimes occur and get a better measure of underlying trends; but when energy prices have risen almost steadily for three years, that concept loses much of its validity. By any other measure, inflation has accelerated over the past year or two.
If you are the sort of person that shops for goods and services -- as opposed to, I suppose, circling the world on your 300-foot yacht and let someone else do all the ordering -- you know that prices are actually rising a lot faster than the BLS says they are. The rate of inflation in the 2001-03 period really was about 3 1/2%, not 2%, and since then it has risen to about 5%. In other words, the official government statistics understate the actual rate of inflation by about 1 1/2%. I have written about this before at some length and most people find it about as interesting as reading the telephone directory, but without as much plot, so I'll skip that here. But if anyone wants to E-mail me to learn the gruesome details, let me know and I'll respond appropriately.
Also, while average hourly compensation probably did rise 5.2% last year -- I'm not disputing that statistic -- it includes all those ridiculous Wall Street bonuses and stock options in the 8-figure range. The average working stiff found his (or her) paycheck rising about 3 1/2% last year, which means that it actually bought 1 1/2% less than the year before. And that trend has now been going on for five years. Even with understated inflation, the BLS series for real wages of production workers shows that.
So even using the understated "official" rate of inflation the figures do show that (a) inflation is rising, (b) it is above the rate the Fed considers acceptable, and (c) real wages for the average worker are falling. If we were to use the actual measure of inflation, the same conclusions would hold, except they would be a lot worse.
I don't know very many people who think 5% is an acceptable rate of inflation. But now comes the oddest part of all; bond market investors, who ought to be the most worried of anyone about high inflation, seemed to have stepped to the sideline. The current interest rate on the long Treasury bond is still under 5% -- i.e., if the true rate of inflation were being measured, the real rate would be less than zero. Why would anyone want to invest in bonds in order to earn a negative real rate of return?
And here is where the flow of global oil money comes into play. At current oil prices, there is over $1 trillion per year in fresh oil money that has to be invested somewhere. It isn't being invested in the oil fields. Not very much is being invested in equities. Most of it is going right into Treasury securities -- U.S., Europe, and Japan. After all, we're not the only country with a big government deficit these days. And these oil producers don't care about the actual rate of return; they want safety and liquidity.
The late Herb Stein was famous for saying, "if something cannot continue forever, it will eventually stop". One day, this whole oil situation will unwind, oil prices will return to normal, and the flow of money into Treasury securities will also stop. When that happens, the rate of inflation will diminish -- but bond yields will rise. Eventually the world economy will return to equilibrium. The only thing that won't change is that production workers will continue to face a declining real wage. In the meantime, the rate of inflation in 2006 will probably accelerate from its levels -- both actual and reported -- in 2005.
It's true that the so-called core rate of inflation -- excluding food and energy -- has hardly budged in recent years, rising 2.2% in both 2005 and 2004, comapred to 2.0% the previous three years. But this is beginning to have a hollow ring. Economic statisticians took food and energy prices out of the core calculation in order to omit the wild monthly fluctuations that sometimes occur and get a better measure of underlying trends; but when energy prices have risen almost steadily for three years, that concept loses much of its validity. By any other measure, inflation has accelerated over the past year or two.
If you are the sort of person that shops for goods and services -- as opposed to, I suppose, circling the world on your 300-foot yacht and let someone else do all the ordering -- you know that prices are actually rising a lot faster than the BLS says they are. The rate of inflation in the 2001-03 period really was about 3 1/2%, not 2%, and since then it has risen to about 5%. In other words, the official government statistics understate the actual rate of inflation by about 1 1/2%. I have written about this before at some length and most people find it about as interesting as reading the telephone directory, but without as much plot, so I'll skip that here. But if anyone wants to E-mail me to learn the gruesome details, let me know and I'll respond appropriately.
Also, while average hourly compensation probably did rise 5.2% last year -- I'm not disputing that statistic -- it includes all those ridiculous Wall Street bonuses and stock options in the 8-figure range. The average working stiff found his (or her) paycheck rising about 3 1/2% last year, which means that it actually bought 1 1/2% less than the year before. And that trend has now been going on for five years. Even with understated inflation, the BLS series for real wages of production workers shows that.
So even using the understated "official" rate of inflation the figures do show that (a) inflation is rising, (b) it is above the rate the Fed considers acceptable, and (c) real wages for the average worker are falling. If we were to use the actual measure of inflation, the same conclusions would hold, except they would be a lot worse.
I don't know very many people who think 5% is an acceptable rate of inflation. But now comes the oddest part of all; bond market investors, who ought to be the most worried of anyone about high inflation, seemed to have stepped to the sideline. The current interest rate on the long Treasury bond is still under 5% -- i.e., if the true rate of inflation were being measured, the real rate would be less than zero. Why would anyone want to invest in bonds in order to earn a negative real rate of return?
And here is where the flow of global oil money comes into play. At current oil prices, there is over $1 trillion per year in fresh oil money that has to be invested somewhere. It isn't being invested in the oil fields. Not very much is being invested in equities. Most of it is going right into Treasury securities -- U.S., Europe, and Japan. After all, we're not the only country with a big government deficit these days. And these oil producers don't care about the actual rate of return; they want safety and liquidity.
The late Herb Stein was famous for saying, "if something cannot continue forever, it will eventually stop". One day, this whole oil situation will unwind, oil prices will return to normal, and the flow of money into Treasury securities will also stop. When that happens, the rate of inflation will diminish -- but bond yields will rise. Eventually the world economy will return to equilibrium. The only thing that won't change is that production workers will continue to face a declining real wage. In the meantime, the rate of inflation in 2006 will probably accelerate from its levels -- both actual and reported -- in 2005.