With productivity slowing down and the dollar trading around multiyear lows against the yen and euro, concerns about inflation are starting to escalate -- again. But consumers, investors and Federal Reserve officials have no reason to panic, and upcoming inflation reports are likely to hammer home that message. The producer price index is expected to climb just 0.1% in November, reflecting a recent decline in oil prices while the core rate is seen rising 0.2%. Meanwhile, the headline and the core consumer price index, due out next week, should increase 0.2%. Recent worries about inflation have centered on declining productivity, the weak dollar and soaring commodity costs. In the third quarter, output per hour worked rose by 1.8%, the slowest quarterly increase since the final three months of 2002. When productivity softens and workers are producing fewer goods and services each hour than they once did, businesses sometimes consider raising prices to increase profits. Ethan Harris, a senior economist at Lehman Brothers, thinks output growth will slow next year to 2% from about 3% currently, but said this rate is still "robust enough to hold core inflation in check." Historically, he said, swings in productivity have had more impact on profit margins than inflation. "Companies are not throwing in the towel on their productivity focus and may in fact be embarking on a renewed round of cost-cutting to protect their margins," said Merrill Lynch economist David Rosenberg. Firms like Colgate-Palmolive ( CL), Bayer ( BAY), JDA Software ( JDAS) and Honeywell ( HON) all plan to lay off workers in the U.S. in an effort to reduce expenses and boost profits. While wages have picked up this year from abnormally low levels, there is still plenty of slack in the labor market and little evidence that labor costs are becoming a concern. In theory, higher wages lead to higher prices, though this doesn't always happen.
Unit labor costs (compensation per unit of output) rose 1.8% in the three months ended September as productivity slowed. But at just 0.8%, these costs are barely in positive territory for the year, and the most recent employment report showed that average hourly earnings rose just 2.4% from last year. Concerns that a weak dollar might raise import prices and stoke inflation also seem to be overblown. "The impact on the CPI of the drop in the dollar over the past few months will be barely visible," said Ian Shepherdson, chief economist at High Frequency Economics. "If the dollar keeps falling, there will be further yet still small effects, surely insufficient to push the Fed onto a faster tightening track." Given the intensely competitive nature of most U.S. goods retailing, higher prices are likely to be absorbed rather than passed along to consumers, Shepherdson said. Those that have tried to pass on higher costs recently, like Wal-Mart ( WMT), have been burned. The world's largest retailer said same-store sales rose just 0.7% in November. A recent survey by America's Research Group shows that consumers simply aren't willing to tolerate price increases. It found that 66% of consumers are waiting for big discounts of 50% off this Christmas. If these kinds of bargains aren't available, they plan to cut spending by as much as 60% to 70%. On Wednesday, General Motors ( GM) said it plans to ramp up incentives after a disappointing November. William Poole, the president of the Federal Reserve Bank in St. Louis, said the drop in the dollar will have no significant impact on inflation, and he has also downplayed concerns about higher energy prices. "I do not believe that the impulses we have seen to date produce any significant change in the inflation outlook," he said last month.
Although oil prices are up sharply from last year, they have fallen precipitously from a high of more than $55 a barrel in October. Nymex crude futures were last sitting at just $41.20 a barrel. Even when oil prices were soaring, however, the core personal consumption expenditure index, the Fed's preferred measure of inflation, rose just 1.5% on a year-over-year basis, hardly a cause for concern. The core consumer price index, meanwhile, is up just 2% from last year. Some economists point out that the core CPI has risen sharply from the 1.3% pace recorded last year. But about half the increase reflects a rise in used car prices, which collapsed in the summer and fall last year amid a flood of new supply. In addition, hotel room rates have rebounded over the past year after being under pressure since the terrorist attacks in 2001. "Their 5.9% increase in the year to October is a return to normality, not the beginning of a sustained acceleration," said Shepherdson. He also noted that core inflation has been pushed up recently by a spate of hurricanes. Nearly half the 0.2% increase in the core CPI in October was due to the 1% jump in household furnishings. "A dispassionate analysis of these distortions makes it hard, in our view, to worry about the recent path of core inflation," he said. Richard Berner, chief economist at Morgan Stanley, isn't so sure. He thinks that Treasury Inflation Protected Securities, or TIPS, are flashing a warning signal. The spread between the 10-year Treasury and 10-year TIPS has widened by about 30 basis points since mid-September, suggesting increased concerns about inflation among market participants. He conceded, however, that TIPS spreads "may be emitting some noise," with money flows and technical factors contributing to the increase.
In addition, he said consumers' inflation expectations remain tame. The most recent survey from the University of Michigan shows that one, five- and 10-year inflation expectations are sitting at just 2.75%. Inflation expectations are important because they can become a self-fulfilling prophecy. If consumers expect prices to rise sharply in the future, they're likely to buy goods today rather than wait. This creates more demand, which sends prices higher. Consumers aren't the only ones with a benign inflation outlook. The Chicago Federal Reserve said it expects the CPI to fall to 2.4% next year from 2.7%, even with a rise in the price of oil to $43.24 a barrel. The Organization for Economic Cooperation and Development and economists surveyed in the Blue Chip newsletter also think prices will rise at a slower pace in 2005 compared with this year, as interest rates go up and economic growth slows down.