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Investing Specialists

A Recovery's Worst Enemy

Higher inflation is a leading cause of recessions.

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The economic data this week generally indicate a stronger manufacturing economy, accelerating inflation, building inventories, and weaker-than-anticipated retail sales. Despite this so-so news, the market reacted kindly with the S&P 500 Index hitting yet another two and a half year high. The S&P has now officially doubled from its low of March 2009 with this week's additional 1% increase. The 10-year bond interest rate managed a small decrease this week as inflation wasn't as bad as the worst fears, and consumer spending looked just a little softer than I had anticipated.

I think the biggest news of the week was a trio of inflation reports that all seemed to point to higher inflation; this could trip up consumers in the months ahead. Although much of the inflation data came in a little lower than expected, the news seems to indicate that year-over-year inflation will approach 2.5% by June, even without very much of an increase in the months to come. The regional manufacturing reports, which the market received so adoringly this week, also contained side notes indicating that inflation is likely to accelerate in the months ahead. In one region, more than half of all manufacturers are planning to raise prices during the next three months.

Weather continued to play havoc with a lot of economic reports, including industrial production and retail sales. I had been looking for a more robust retail sales report, but a decline in restaurant sales and building materials both had a dramatic impact on overall results. Given better consumer spending trends, an outright decline in restaurant sales came as quite a surprise. However, unlike regular retailers, restaurants can't make up for a lost sale when the weather improves. A weather-related restaurant closing amounts to business permanently lost. Grocery stores, on the other hand, will make up for bad weather with increased sales both before and after a storm. Though I am watching the consumer closely, this report is not the reason to panic. Higher inflation is a far bigger cause for concern.

Higher Inflation, a Leading Cause of Recessions
In this week's video we highlighted the importance of inflation in predicting the end of recessions. When prices of goods move up faster than incomes, consumers are constrained, forcing them to cut back on consumption (or dip into savings). Slowing consumption in turn slows overall GDP growth and forces manufacturers to cut back on production and employment. Until recently both wage growth and inflation were muted, though it now appears that inflation is gaining the upper hand on wage growth. Therefore, I am carefully monitoring the relationship between hourly wage growth and inflation for further changes.

Consumer and Producer Prices Both Jump
This week we received news on the inflation front from both consumers and producers as the Consumer Price Index moved 0.4% (4.8% annualized) and the Producer Price Index moved to an even stronger 0.8%.

The CPI is the most important of the two metrics in determining consumer spending habits. The PPI is far less important, although it can provide some clues about the future of the CPI, so it can't be completely ignored. The PPI covers primarily goods and doesn't cover the larger services sector of the economy. Also, the PPI is very volatile, and many times producers opt not to pass all increases on to consumers. Nevertheless, an accelerating PPI often eventually leads to an increase in the CPI, albeit generally of a smaller magnitude. With the PPI continuing to show brisk increases, I suspect the CPI will continue to increase in the months ahead.

 Inflation Appears to Be Accelerating: CPI and PPI Growth (%)
                                          Consumer Price Index                           Producer Price Index


Aug 20100.21.2 0.63.3
Sept 20100.21.2 0.33.7
Oct 20100.21.2 0.63.8
Nov 20100.11.1 0.73.9
Dec 20100.41.2 0.93.9
Jan 20110.41.4 0.83.8
6 Months Annualized3.2  7.7 
Source: St. Louis Federal Reserve, Morningstar Calculations

Putting together last week's wage data with this month's CPI data, we can see that the consumer has lost ground over the last six months, as the hourly wage went up 2.7% (annualized) but inflation increased by an even larger 3.2%, wiping out those gains. Though this series is volatile on a monthly basis, at least the consumer managed to gain a little ground in the most recent month as shown in the table below.

 Inflation Outstrips Hourly Wage Growth (Monthly Changes %)
 Hourly WageInflationInflation-Adjusted
Aug 20100.30.20.1
Sept 20100.10.2-0.1
Oct 20100.50.20.2
Nov 20100.10.1-0.1
Dec 20100.00.4-0.4
Jan 20110.50.40.1
6 Months Annualized2.73.2-0.5
Source: St. Louis Federal Reserve, Bureau of Labor Statistics

I will monitor the data closely in the months ahead for further slippage. In the short run, the recent payroll tax cut could help consumer spending, at least for a few months, potentially offsetting my concerns regarding the real hourly wage.

Analyzing the CPI category by category, accelerating headline inflation has not led to large across-the-board increases. In fact, some items actually showed price declines this month.

 January Monthly Inflation Data Shows Winners and Losers
Biggest Gainers


 Biggest Losers 
Energy+2.1 Electricity-0.6
Clothing+1.0 Natural Gas-0.5
Food+0.5 Used Cars-0.3
Transportation+0.6 New Cars-0.1
Medical Goods+0.5 Medical Services-0.1
Source: Bureau of Labor Statistics

The ups and downs of various categories would seem to support those who are optimistic that inflation will not spread from commodities to the rest of the economy. Having grown up in the 1970s, I still am in the camp that says rising commodity prices will continue pushing overall inflation up. Inflation in both Europe and developing markets is accelerating. This has caused wage growth in both developed and emerging economies. In fact, a combination of accelerating inflation and tight labor markets enabled German workers at Volkswagen to extract a very healthy 3.2% wage increase from their employer in recent weeks.

 Inflation Rears Its Head Outside the U.S.
 Recent Year-Over-Year
Inflation % (Jan. 2011)
Source: U.S. Bureau of Labor Statistics;
Wall Street Journal

Given these accelerating wage and price trends overseas, and the fact that the United States imports a large portion of its consumer goods, I suspect some of the overseas increases will continue to trickle into the U.S. statistics in the months ahead. Just this week, a broad index of import prices showed a jump of 1.5%, or 18% annualized. The trend has been accelerating for some time, as shown in the table below.

 Will Higher Import Prices 
 Sneak Over the Border?
 % Change in Monthly,
Non-Fuel U.S. Import Prices
Aug 20100.3
Sept 20100.3
Oct 20100.3
Nov 20100.8
Dec 20100.3
Jan 20110.8
6 Mo. Ann.5.7
Source: Bureau of Labor Statistics


Manufacturing Is Not the Key Driver of the Economy
The news out of manufacturing this week was mixed on the surface, but peeling back some layers from the onion revealed a brighter picture over the near term. While I am pleased with the manufacturing data, I need to remind everyone that ultimately consumer spending drives manufacturing--not vice versa--at this stage of the recovery.

Early on in a recovery, manufacturing usually makes a very sharp rebound. At the early stages, manufacturers benefit from increased user demand plus the need to replenish badly depleted inventories. Now with inventories on the rise again, new manufacturing demand must come from consumers. That's why I am watching inflation and consumer incomes so closely.

The market seemed enamored with the manufacturing numbers this week. But just as poor manufacturing numbers didn't sink the economy this fall, I don't believe this week's strong manufacturing data are a good enough reason to raise economic forecasts.

Weather Causes a Disappointing Industrial Production Report
On the surface, the industrial production report was a disappointment, as weather and utility output caused industrial output to decline 0.1% sequentially, and year-over-year growth was down to just 5% compared with double-digit growth rates early in the recovery.

Industrial production has now recovered approximately 70% of the production that was lost during the recession. A 1.6% decline in utilities weighed on the overall index, driven by weather that was snowy but not nearly as cold as December. Overall, the manufacturing part of the index grew 0.3% sequentially, driven by a gain of almost 3.0% in the auto category. On the other hand, anything related to housing remained in the dumps. The other durable goods category, which includes appliances, furniture, and carpeting, fell 1% according to Morningstar's industrials team.

Regional Purchasing Managers' Reports Suggest a Bright Manufacturing Outlook
The industrial production report was for January, and we now have some regional purchasing manager reports that suggest acceleration in the manufacturing sector during February. Both the Philly Fed and the Empire State Manufacturing reports showed sharp acceleration and exceeded expectations.

Eric Landry of Morningstar's industrials team points out that the Philly Fed is one of the most predictive leading factors for forecasting industrial production. The Philly Fed index of manufacturing reached a seven-year high of 35.9 versus a reading of 19.3 for the prior month. The subindexes, including new orders and shipments, also hit a seven-year high. The employment portion of the index hit its highest level since 1973, according to Capital Economic, an economic forecasting group. In a special question in this month's survey, 57% of the firms indicated they had raised prices already this year, with a 3%-4% increase being the most common. Numbers were nearly identical when the survey group was asked about the next three months. That seems to imply that we should all expect more inflation in the months ahead.

Composite numbers for the Empire State manufacturers were also better in February, but not nearly as dramatically as in the Philly Fed report. Both manufacturing reports suggest that soft industrial production numbers for January were probably weather-related and have already started to bounce back.

Why Has Manufacturing Looked Better Lately?
I think manufacturing looked better because of improvement in the auto sector, which seems to weigh on a number of manufacturing indexes more than it should. Last year's lack of a summer shutdown made the spring before and the fall after that period look weaker when standard seasonal adjustment factors were applied. Now that most of those effects have washed through the system, auto numbers are looking better again. Beyond the statistical abnormality, auto manufacturers are also ramping up production, with  Ford (F) alone hiring 7,000 new manufacturing employees. Customer demand at the end of 2010 combined with relatively successful new model introductions have caused automakers and their entire supply chain to ramp up.

Exports of capital goods to emerging markets as well as strong farm equipment sales (due to strong crop prices) have helped as well. Our industrials team also points out that many of the manufacturers that are doing well are late-cycle companies (companies that perform well in the later stages of an economic recovery) that tend to make equipment for other manufacturing plants--such as  Rockwell (ROK), which makes a lot of factory control equipment). Growth in business-related manufacturing has outstripped production of consumer goods by a factor of 5 over the last year. It's too bad that the business sector is so small compared to the consumer.

Lots of Meaningless Housing Data Due Next Week
Next week most of the data relates to the housing industry, with the Case-Shiller Price Index due on Tuesday and existing home sales and new home sales due later in the week. Given a rush to sell homes before new regulations in California went into effect in last month's data, I expect a meaningful decline, but don't let it scare you. Case-Shiller data will also likely show a small decline. Existing home sales should eke out a small single-digit gain given the pending home sales that have already been released.

Fourth-Quarter GDP Estimate Could Be Raised Modestly
Higher inventories and revised net exports probably mean an upward revision in the fourth-quarter GDP estimate. The first estimate came in at an improved but below-expectation rate of 3.2%. I suspect the latest revision, due Friday, will be raised up to the 3.5%-4.0% range. This just might excite the market (if I am right) as expectations are for no revision at all.

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.