Inflation -- as measured by the consumer price Index, anyway -- showed a huge drop in November. Driven by a 16% plunge in energy prices, this broad measure of inflation at the consumer level fell by 0.6% from October. That's the biggest monthly decline in inflation since 1949, and it reset the annual inflation rate to 3.5% from a 4.3% reading in October.But before you break out the champagne, I suggest you take a look at the evidence that the global system for producing and delivering commodities is breaking down under the pressure of demand. The world may indeed have plenty of oil, coal, copper, iron, nickel and other essential industrial commodities in the ground to meet current demand -- especially with the big incentives to production that current high prices provide. But there's increasing evidence that commodity industries are suffering from shortages in key materials, gear and personnel. And because of those shortages, they can't get the oil, coal, etc., out of the ground without substantially higher production costs. And that argues that we're in for another round of commodity inflation in 2006 that will increasingly feed inflation for the economy in general. In November, the core CPI -- that's the CPI with the effects of food and energy prices stripped out -- climbed by 0.2%. That doesn't seem like much, but November marked the second consecutive month when the core rate climbed by 0.2% instead of the 0.1% monthly increases of April through September. In January 2004, the core CPI hit a 40-year low at an annual rate of 1.1%. With the November number, the core CPI is showing annual inflation of 2.1%. That's still low, but you don't have to be chairman of the Federal Reserve to know which way the trend is headed.
If core inflation gets worrisome enough, the stock and bond markets can forget about the Federal Reserve moving to the sidelines after one or two more interest rate hikes in 2006. That wouldn't be so important except that the bullish case for stocks in 2006 hinges on an early end to the Fed's interest rate increases. If commodity inflation in 2006 leaks through into higher core CPI inflation, you can forget about that scenario for the Fed -- and forget about a good year in 2006 for stocks and bonds.
If it were just a question of tires, even of tires across a huge swath of the U.S.-Canada coal and oil-sands belt, I don't think this would be a big enough problem to bump up the core inflation rate in 2006. But it's not limited to this one problem.
Strains that are showing in the global commodities supply system say that meeting even that modest growth in demand with a matching increase in supply isn't by any means a sure thing next year. And that much of this new supply will come on line with substantially higher production costs. This isn't rocket science but basic classical economics: When a system operates at the edge of full capacity, prices rise as unexpected glitches slow production here and there or require extraordinary efforts and extra costs to keep the system running. I think that's what we can expect in most global commodities markets in 2006.