May 10, 2007

The FOMC is stuck between a Rock and an ''Almost Hard Place'.'  The rock is the increasing level of Inflation and the risk of accelerating Inflation.  The 'Almost Hard Place' is their inability to raise Interest Rates in the face of it.

In it's policy statement on Wednesday the FOMC disclosed that the concerns about accelerating Interest Rates were at the forefront of their agenda.  Here's a direct quote from the FOMC's policy statement: "...the Committee's predominant policy concern remains the risk that Inflation will fail to moderate as expected."

I have since taken the liberty of evaluating just how serious this issue may be, and in doing so I have come to some startling conclusions.  These basis can be found in the numerous charts at the bottom of this page; the conclusions are clear: the FOMC has their hands tied.

The first step is to evaluate Inflation, so I took a sample directly from the Bureau of Labor Statistics in an effort to gauge increases over time.  My initial interest was to find the patterns of wage growth over time to determine if wage growth should be a major concern to increasing prices.  The concern, I have found, is not necessarily in the growth of wages, but more so in the lack thereof.

My sample encompassed the period of 2000-2007.

Again, from the BLS, I made further evaluations of the prices of food products and energy in major US cities in an effort to understand the relationship between prices and wages.  The study included electricity, natural gas, fuel oil, gasoline, bread, ground chuck, chicken, eggs, apples, oranges, tomatoes, bananas, coffee, concentrate, and lettuce.  These are not lifestyle choices, these are necessities.  Although these are considered the volatile part of the CPI, these are the things that we must spend money on every month in order to survive.

Clearly looking at these components on a monthly basis can distort the findings of the CPI because these prices can be extremely volatile month-month.  However, on a longer term basis, like the one used in this study, the change in prices of these components is very important, and should be closely studied.

The comparisons between 2000-2007 showed me that the prices of these goods and services increased at almost twice the rate of wages during the same timeframe.  Wages increased by 17.9% between 2000-2007 (weekly wages nationwide according to BLS).  During that same timeframe the prices of these components grew by 37.6% (Data source: BLS).   These prices outpaced wages by 110%.  (See the charts below for details)

How can prices outpace wages?

No one wants to sacrifice the lifestyles that they have been accustomed to if they have the choice, so if their disposable incomes start to deteriorate in relation to their day-day expenses they will first try to find a way to pay for those added costs before accepting a reduced lifestyle.  This is human nature; people are reluctant to move backwards or make sacrifices unless there are compelling reasons to do so.

In the last handful of years there has been very little reason to worry.  Even in the wake of the internet debacle, and even in the face of a slumping housing market more recently, the economy still looks healthy, so sentiment remains robust.  That positive sentiment makes us believe that we don't need to worry about adverse economic conditions.

This has opened the door for increasing levels of debt in US Households.  In fact, very recently the savings rate has turned negative for the first time.  This means that US Households were actually pulling money out of their savings instead of adding to it (they would never do this if there were economic concerns unless their hands were forced).  In this environment, they are doing this to maintain lifestyle.

The best way to explain the severity of this point is in graphical form.  I have taken this graph from yardeni.com.  It is 1 year old, but it demonstrates the dichotomy between savings and debt very well.  The level of debt is escalating exponentially, while net savings is declining.  In essence, we have more debt and less equity because we feel that the economy is unlikely to experience adverse conditions.

This leads us to our next obvious question, a question about debt.  Children often do what they see their parents doing, and the same might be true for US citizens in relation to the Federal Government.  Our Government is spending money at a much faster pace than it should.  In the chart to the right.  The total amount of US debt is shown to be accelerating at a much faster pace than the level of income.  Really, how long can this last?  If you ever wondered why the dollar is weakening, this chart can help you understand why.

Consumers are accepting higher levels of debt to afford the increasing costs of living, and they are not afraid to do so because the cost of money is comparatively low to the early 80's, which most people remember.  However, Interest Rates are slightly under historically normal levels.  The Fed funds rate has averaged 5.7% since 1955, and it is currently at 5.25%.  The FOMC has tried to position itself in such a way as to remain flexible, and according to historical measures, it does have room to move in either direction.

But the FOMC is limited.

Money supply is plentiful, this is evident in the Money supply chart below.  The abundance of liquidity has made M&A activity robust, and it has allowed the government and institutions to assume higher and higher levels of debt.  Initially this could be construed as a positive thing; influencing economic activity is something that we all consider positive.  However, in this case, the ability to control Inflation seems sacrificed.

Let's look at both sides of the Interest Rate picture.  First, the possibilities of lower Interest Rates: the FOMC could hardly justify lowering Interest Rates in this economic environment.  Money is already easy, the economy is healthy, the stock market is at historical highs, and economic activity on a corporate level is robust.  Nothing in the current environment, aside from a slump in housing, suggests that the FOMC should or will cut Interest Rates anytime soon.

On the other hand, with the fear that Inflation will not moderate, a bias to increase Interest Rates to control Inflation exists.  However, with the extremely high levels of US debt, and with the already slumping housing market, an increase in Interest Rates would devastate the economy.

First of all, the demand for housing is already weak, higher Interest Rates would only further that phenomena, and drive home prices lower.  Subprime, in this scenario, would only be the tip of the iceberg.  Next, credit card debt, and other non-mortgage related debt: according to the Federal Reserve the percentage of debt burden to income in the US is 25.5% for renters and 18.2% for home owners nationwide on average. 

Historically high levels of debt limit the ability of the FOMC to control Interest Rates.

If the FOMC increased Interest Rates by just 50 basis points (to match the historical average) $240 Billion would be taken out of the economy (based on 2006 debt levels).  The housing Market would deteriorate even further, the debt/equity levels of US Households would diverge even more than they are now, and the US Economy would face serious economic recession.

The FOMC is caught between a rock and an 'Almost Hard Place,' and that 'Almost Hard Place' if firming up quickly.  If Inflation begins to accelerate, the FOMC will face one of the most important decisions in US History: do we let Inflation increase, or raise Interest Rates and face economic recession?

Although new data comes out at the end of this week, the higher than expected level of PPI in the last report could be a sign that eventually prices will begin to rise on the consumer side too.  In the face of a slower economy, after all, companies still need to make money; Wall Street is impatient that way.  If they need to do it by raising prices, they will if they can.

Earnings:            Median usual weekly earnings - 

in current dollars (second quartile)
Industry:            All Industries
Occupation:          All Occupations
Sex:                 Both Sexes
Race:                All Races
Ethnic origin:       All Origins
Age:                 25 years and over
Education:           Total
Class of worker:     Wage and salary workers, 

excluding incorporated self employed
Labor force status:  Employed full time

Total % gain of wages:  17.9%
Annualized:  2.56%

Total price increase of sample: 37.6%

annualized: 5.38%

Consumer Price Index - Average Price Data   Series Id:  APU000072621 Area:       U.S. city average Item:       Electricity per 500 KWH Total % gain:  30.5% Annualized:  4.5%   Year Jan 2000 45.207 2001 47.472 2002 47.868 2003 47.663 2004 49.159 2005 50.847 2006 57.223 2007 59.043     Series Id:  APU000072611 Area:       U.S. city average Item:       Utility (piped) gas - 100 therms Total % gain:  91.2% Annualized:  13%   Year Jan 2000 68.650 2001 111.750 2002 78.956 2003 88.141 2004 102.739 2005 114.508 2006 152.755 2007 126.568     Series Id:  APU000072511 Area:       U.S. city average Item:       Fuel oil #2 per gallon (3.785 liters) Total % gain:  99.1% Annualized:  14.2%   Year Jan 2000 1.189 2001 1.509 2002 1.123 2003 1.396 2004 1.508 2005 1.859 2006 2.418 2007 2.368     Series Id:  APU000074714 Area:       U.S. city average Item:       Gasoline, unleaded regular, per gallon/3.785 liters Total % gain:  75% Annualized:  10.7%   Year Jan 2000 1.301 2001 1.472 2002 1.139 2003 1.473 2004 1.592 2005 1.823 2006 2.315 2007 2.274     Series Id:  APU0000702111 Area:       U.S. city average Item:       Bread, white, pan, per lb. (453.6 gm) Total % gain:  27% Annualized:  3.9%   Year Jan 2000 0.907 2001 0.982 2002 1.001 2003 1.042 2004 0.946 2005 0.997 2006 1.046 2007 1.153     Series Id:  APU0000703111 Area:       U.S. city average Item:       Ground chuck, 100% beef, per lb. (453.6 gm) Total % gain:  38% Annualized:  5.5%   Year Jan 2000 1.903 2001 2.037 2002 2.152 2003 2.131 2004 2.585 2005 2.478 2006 2.607 2007 2.630     Series Id:  APU0000706111 Area:       U.S. city average Item:       Chicken, fresh, whole, per lb. (453.6 gm) Total % gain:  nil Annualized:  nil   Year Jan 2000 1.059 2001 1.091 2002 1.091 2003 1.004 2004 1.062 2005 1.026 2006 1.062 2007 1.033     Series Id:  APU0000708111 Area:       U.S. city average Item:       Eggs, grade A, large, per doz. Total % gain:  59% Annualized:  8.4%   Year Jan 2000 0.975 2001 1.011 2002 0.973 2003 1.175 2004 1.573 2005 1.211 2006 1.449 2007 1.549     Series Id:  APU0000711111 Area:       U.S. city average Item:       Apples, Red Delicious, per lb. (453.6 gm) Total % gain:  8.6% Annualized:  1.2%   Year Jan 2000 0.952 2001 0.808 2002 0.877 2003 0.977 2004 1.019 2005 0.966 2006 0.963 2007 1.034     Series Id:  APU0000711311 Area:       U.S. city average Item:       Oranges, Navel, per lb. (453.6 gm) Total % gain:  80% Annualized:  11.4%   Year Jan 2000 0.607 2001 0.638 2002 0.715 2003 0.713 2004 0.793 2005 0.838 2006 0.837 2007 1.092     Series Id:  APU0000711211 Area:       U.S. city average Item:       Bananas, per lb. (453.6 gm) Total % gain:  nil Annualized:  nil   Year Jan 2000 0.490 2001 0.500 2002 0.509 2003 0.526 2004 0.512 2005 0.485 2006 0.490 2007 0.505     Series Id:  APU0000712311 Area:       U.S. city average Item:       Tomatoes, field grown, per lb. (453.6 gm) Total % gain:  12.5% Annualized:  1.8%   Year Jan 2000 1.443 2001 1.414 2002 1.451 2003 1.711 2004 1.472 2005 1.660 2006 2.162 2007 1.621     Series Id:  APU0000713111 Area:       U.S. city average Item:       Orange juice, frozen concentrate, 12 oz. can, per 16 oz. (473.2 ml) Total % gain:  27% Annualized:  3.85%   Year Jan 2000 1.823 2001 1.863 2002 1.876 2003 1.848 2004 1.957 2005 1.872 2006 1.853 2007 2.314     Series Id:  APU0000717311 Area:       U.S. city average Item:       Coffee, 100%, ground roast, all sizes, per lb. (453.6 gm) Total % gain:  -7% Annualized:  -1%   Year Jan 2000 3.540 2001 3.224 2002 2.936 2003 2.999 2004 2.892 2005 3.049 2006 3.232 2007 3.288     Series Id:  APU0000712211 Area:       U.S. city average Item:       Lettuce, iceberg, per lb. (453.6 gm) Total % gain:  24% Annualized:  3.4%   Year Jan 2000 0.748 2001 0.736 2002 1.003 2003 0.734 2004 0.876 2005 0.817 2006 0.874 2007 0.926

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