Looked at Chinese Food Prices Lately?

The Chinese may have a harder time making ends meet, signaling more U.S. inflation pressure.
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This business cycle has been cruel to forecasters who based their models on simple analogies to past patterns.

It started with the late 1990s boom, during which inflation stayed low despite the virtual absence of

Fed

rate hikes, leading some surprised forecasters to proclaim a new paradigm of endless noninflationary growth.

Of course, that boom was followed by the first business-led recession since World War II, making it even harder than usual to predict. Then came the recovery, during which many pundits kept calling for a double-dip recession that never arrived, based on past patterns.

The optimists then called for strong GDP and job growth, oblivious to the rapid structural change that was decimating manufacturing jobs. Recognition of that shift led me to

predict a lopsided recovery, featuring "a pickup in GDP growth, but not so much in job growth."

Finally, early this year, with the outlook finally changing, I

forecasted a noticeable pickup in job growth. That did happen, despite the gloom of many analysts as late as the first week of April.

The success or failure of much that we do -- buying a home, quitting a job to start a new business or investing in financial markets -- depends critically on the timing of that decision, even when the decision itself might be correct. That's why it's so vital to have state-of-the-art predictors of the timing of economic turning points, ones that recognize that GDP growth doesn't always equal job growth, that a recession doesn't always make home prices dip and that the economy can experience growth without inflation, as in the late 1990s, or its opposite, 1970s-style stagflation.

Over the years, I've used these kinds of tools -- such as the Weekly Leading Index, or WLI, designed by the Economic Cycle Research Institute to predict turning points in economic growth, and the Future Inflation Gauge, or FIG, which anticipates turning points in inflation -- to make accurate forecasts. Some weeks ago, when the markets worried about job growth instead of inflation, the upturn in the FIG since the end of 2003 was already warning of rising inflation pressures. Today, inflation has become a major concern.

The Importance of Chinese Food Prices

Many who are sanguine about inflation argue that its main driver is labor costs, which make up two-thirds of the costs of U.S. firms. Higher industrial commodity prices don't worry them because they represent less than a tenth of those costs.

Perhaps these optimists haven't realized how much manufacturing capacity has gone to places like China, especially over the past couple of years, mostly due to drastically lower labor costs. Now China is the price-setter in many product categories, even when some of those goods are still being made in the U.S.

What does that mean for the importance of industrial commodity prices? After all, labor costs are far less than two-thirds of manufacturing costs in China -- that's why production moved there in the first place. The flip side is that raw material costs must be a much greater proportion of costs than they are in the U.S. If so, the rise in industrial raw-material prices should have significantly boosted the costs of Chinese manufacturers. How about their labor costs?

It's important to understand what the typical Chinese worker does with his or her wages. As in many low-wage developing economies, much of it goes toward buying food -- a far greater proportion than in the U.S. Food is

the

core expense. This is why it's vital to appreciate what's happened lately to Chinese food prices.

While food prices have risen in both the U.S. and China, partly due to poor harvests in both countries, the rise has been far more significant in China. After staying essentially flat for years, the Chinese consumer price index for food rose by more than 12% just between June 2003 and January 2004, at a torrid 22% annual rate. While the pace of increase has since moderated, food prices haven't fallen back.

For the average Chinese worker, it's now much harder to make ends meet. Anecdotal evidence suggests that Chinese employers are being forced to boost wages as a result. Of course, they also have to contend with the rise in raw-material costs.

The upshot, according to further anecdotal evidence, is that many Chinese suppliers are successfully passing on the higher costs to U.S. buyers this year. As the price-setters at the margin, they are in effect allowing their competitors to raise prices as well. The likely result is a rise in U.S. inflation pressures.

So the next time some economist tells you that his or her regression model shows U.S. labor costs to be the key to subdued inflation, just remember Chinese food prices and raw-material costs. The moral of the story is that it isn't enough to pay lip service to the global economy -- you need to factor it into your calculations, as the FIG does. And the FIG has been on the rise.

When Will the Housing Bubble Burst?

Many people have been waiting for years for the housing bubble to pop. As a result, they may have made decisions they have come to regret. When will the day of reckoning finally arrive?

For an answer, let's turn to ECRI's Leading Home Price Index, or LHPI, which correctly predicted the sustained rise in home prices in recent years despite the recession. As the chart shows, the LHPI (top line) turned down in anticipation of every cyclical downturn in inflation-adjusted home prices (bottom line), which are marked by the shaded areas. But in this recession, the LHPI stayed firm and remains in a clear uptrend, implying that any downturn in home prices is far from imminent.

Housing on Fire?
Don't look for an imminent downturn in housing prices

The LHPI is designed to predict cyclical turns in real, or inflation-adjusted, median U.S. home prices. To calculate those prices, we combine the prices of new and existing homes.

Notably, for the country as a whole,

nominal

home prices, without adjusting for inflation, show no cyclical downturns. Also, it is mostly in places like New York City and parts of California, where land is relatively scarce, that home prices actually swing up and down over time. In much of the country, home prices might rise more slowly or quickly at different times, but they don't actually show cyclical downswings.

The bad news is that at some point, home prices are likely to fall, especially in places that are subject to those cyclical swings, and certainly in inflation-adjusted terms. Fortunately, those downturns are not yet in sight.

How can you use the WLI, FIG and LHPI to predict turning points in the economy, inflation and home prices? To answer that question, we just wrote

Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy

.

The Good News

Growth in the WLI has eased since last summer, and is now nearing a one-year low. Thus, U.S. economic growth is also set to moderate in the months ahead.

WLI growth is still comfortably positive -- a good sign. It means that the economy is not vulnerable this year to any but the most massive of shocks. So, while there are many reasons to worry, ranging from the geopolitical situation to high oil prices, they are unlikely to tip the economy over into a new recession this year.

Anirvan Banerji is the director of research for the

Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City and is the co-author of

Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy

. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at

anirvan.banerji@thestreet.com

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