USA INFLATION (NOT DEFLATION) IS THE NEAR-TERM RIS

Earlier this afternoon, Nickoo posted more details concerning his deflationary outlook for the USA. It is an outlook (at least in the deflationary context, and in the growth outlook) which I do not subscribe to, either in the US, global, or local context.

Certainly, various parts of the local and global economy are suffering from a depressed outlook, the high tech sector (comprising IT, telecoms, and other forms of technology), are suffering from this circumstance (ie: as much due to managing an excess of capacity, and re-educating the public regarding the pricing fundamentals underlying hi-tech, as it is due to potentially premature outlooks, and overly ambitious adoption rates and consumer penetration levels).

The underlying physical economy, however, is not anywhere near as depressed as what Nickoo and other posters have been arguing (as my earlier response to Bligh concerning the "all areas" GDP outlook sought to demonstrate - see posting on 28/07/02; and my even earlier posting in response to Bombadier on the US and global economic outlook - see posting on 24/06/02).

The purpose of tonight's posting, however, is to concentrate on the question of inflation, and the inflationary outlook for the US in coming months.

In this regard, it is interesting to note the recent CPI advances in the US.

Yes, core inflation is currently benign, but this is largely due to the declining impact of energy prices over the last 12 months. Equally, however, core inflation is also at direct, and immediate, risk of trending upwards. Inflation, rather than deflation, therefore, is more the prognosis for the US in the coming forecast period.

Goods inflation (ie: that which relates to the physical side of the economy) remains modest, albeit with a slight up-tick in recent times).

Taking this further, the most recent CPI data for the USA shows the following:
1)
Service prices (excluding energy) is up 3.7% in the 12 months to June, 2002, whilst rising 0.1% in June. As the US has moved into its summer sojourn, services’ prices have declined marginally from an annualized rate of 4%, to the current 3.7%.
2)
Food prices were up 1.6% in the June year, following a –0.2% rise in the 12 months to May (ie: reflecting the overall volatility implicit in this sector of the consumer pricing basket).

In June, energy prices were benign, whilst reflecting a yoy change of –11.1%. In June, petrol prices rose 0.4% (annualized, 4.8%) whilst electricity and natural gas prices fell 0.2% (annualized, 2.4%), reflecting the positive impact of the additional production capacity that has been commissioned into service over the last 18m (primarily in response to the early ’01 energy crisis in California).

Overall, the CPI readings remain benign as they continue to wash through the impact of a beneficial fall in energy prices. Having recorded a 0.1% rise in June (annualized, 1.1%), CPI is likely to remain benign until the October readings finally wash through the energy impact (ie: unless there is a further fall in energy prices going forward from today).

Stripping the CPI figures of their food and energy impacts, core underlying inflation is 2.3% up on June 2001 (having recorded a 0.1% rise in June). Whilst this represents a modest deceleration from earlier readings in 2002, the current trending range is 2.2% - 2.6%. Overall, neutral (if sustained), but at risk if either energy prices resume their rise, or if the rise in services’ inflation gathers pace.

At the core, goods’ prices decreased 0.1% in June, for a -1.0% yoy result, to June 2002.

As for the other influences on CPI, the following was apparent from the June result of 1.1% core (2.3, headline):
1)
apparel prices down 2.9% yoy (-0.9% in June; -0.6% in May);
2)
medical care prices were up 4.5% yoy, continuing with the rate of acceleration evident over the last 2 years (+0.2% in June, and +0.5% in May);
3)
education and communication prices were up 2.4% yoy (+0.3% in June);
4)
housing costs were up 1.9% yoy (+0.1% in June) notwithstanding the increased affordability of housing (now near its lowest level in the last 30+ years), and a falling interest rate environment;
5)
recreation prices were up 1.3% yoy, despite a 0.3% decline in June (following on from a decrease of 0.1% in May); and
6)
“other goods and services” rose 1.0% in June following a decrease of 0.5% in May (largely impacted by tobacco related prices which were up 4.1% in June, following a decline of 2.7% in May.

In commenting on these results, Prudential Bache observed that “(o)ver the past year, upward pressure on the core CPI has come from services while goods have been a restraining influence. The hint in the new figures (,therefore,) is that a little deceleration has begun to emerge in services”.

Conversely, in recent years, services’ prices have trended sub-3%, whilst goods’ prices have trended +1.0%. Much of the recent decline in overall US CPI to its current 2.3% trend can, therefore, be attributed to falling prices in the goods’ sector.

Going forward, I would argued that US CPI will up-tick unless:
1)
AT THE CORE - services’ prices can be reduced back to below their 2.5% trend (last evident in 1998);
2)
AT THE CORE - goods’ prices remain in their current –1% trend (not previously evident, except in late 2001, and currently forming a reversal pattern);
3)
AT THE HEADLINE – energy prices remain either in decline, or remain flat from here on in (not likely going forward, with a 11+% decline already factored in over the last 12 months);
4)
AT THE HEADLINE – food prices remain in decline (not currently evident); and
5)
AT THE CORE – wages inflation is contained (this, however, will prove a little difficult with last week’s wages’ outcome demonstrating that US wages inflation is now increasing at an annualized 3.5% rate).

Adjusted for all these influences, I would also argue that:
1)
headline CPI is likely to bounce back towards 2.5% by year’s end (currently at 1.2%);
2)
core CPI is likely to remain stable to up-trending towards a near 3% range (due to goods’ prices reversing; and
3)
services inflation will remain well above 3.0% (indeed, trending back towards a 4.0%+ result).

Further adjusted for the following, I would conclude that the US inflationary outlook is more at risk of up-trending inflation, rather than down-trending inflation, or even, deflation:
1)
a depreciating USD (the recent depreciation effects on the $ are currently starting to filter through into higher landed import prices);
2)
energy (oil) prices bouncing back off their low water marks (including the real likelihood of a spark price spike in the event of any Middle East impacts, whether war, terrorism, or any future scaling back in OPEC output);
3)
energy (electricity) prices increasing off a benign regulated base (ie: in recent times, prices have been kept low due to the commissioning of additional generation capacity, and legislative pricing controls over electricity prices due to last year’s energy crisis – now being relaxed); and
4)
increased capacity utilisation which whilst below the long-term productive average ie: 81.9% over the last 35 years), has nonetheless increased sharply in recent months (now at 76.1% in June, up from the December “recession” low of 74.4%) which, if maintained at its current pace, will approximate 79% by year’s end (ie: a point at which wages inflation will start to re-emerge, along with component shortages in certain key parts of the economy, particularly given the 18 –24m lead-time typically associated with the design, construction and commissioning into service, of new productive capacity). An upward trending capacity utilisation ratio could quite easily add a further 150 -200bp to the inflation outlook over the next 15 –18 months (above all other factors).