Prices: The Pressures Rising

This week the Federal Reserve released its Beige Book, which is a compilation of economic surveys taken through the better part of March till April 4^th.  According to the report, the economy improved in all 12 Federal Reserve districts.  A sign that stimulus provided by current monetary policy, such as QE2, is having the desired positive impact.

Gains in manufacturing activity were expressed by every district, while modest increases in consumer spending were seen in a majority of districts.

The survey’s results were basically in-line with economic reports released the past week, showing growth for the month of March.

Industrial production in the U.S. grew by 0.8 percent in March, while capacity utilization increased to 77.4 percent.  Retail sales rose 0.4 percent in March, generally in-line with economists’ expectations.

The above are good items for the economy and certainly represent a trend I hope continues.  More economic activity means more jobs and less unemployed Americans, which is the Fed’s main motivation for current monetary policy.

The flipside of this coin is the rising price pressures that have continued to build through the first quarter of 2011.  As discussed in the last letter, the Fed’s QE2 (second round of quantitative easing) is an act of currency devaluation. 

The unintended effect of this policy is the additional pressure added to prices for basic materials (commodities), which is eventually past onto consumers as goods.  We as consumers have thus far been insulated from this phenomena, with the glaring exception of oil & gasoline (I’m afraid to visit the gas station these days).

The below chart shows an aggressively increasing Consumer Price Index (CPI); a large chunk of the recent increases are due to the rise in oil, the second largest driver is the rise in food costs.

Retailers have done their best to minimize the costs they pass to the consumer in fear of losing business with the economy, and American consumer for that matter, still in a the recovery phase of the economic cycle.  However, this will not last much longer as large brand-name manufacturers, such as Colgate and Procter & Gamble announced 5 to 7 percent price increases in recent weeks.  These increases will likely get passed down to us, the consumer, at retailers such as Wal-Mart and Target.

In fact, Wal-Mart CEO Bill Simon recently stated that “Inflation is going to be serious.  We are seeing cost increases starting to come through at a pretty rapid rate.”

Now, an environment of rising prices isn’t always a bad thing.  Generally when you have increased economic activity and accelerating spending the price of items rise, it’s simple supply and demand.

The issue IS that average workers wages are not rising!  The Bureau of Labor Statistics reported earlier in the month that hourly earnings in the U.S. were flat in March, though a 0.2 percent rise was expected.  Wages were flat in February as well. 

This compares to a 0.5 percent rise in the CPI for February and March.  This divergence cannot become a long-term trend as our earnings will buy us less goods, weighing on consumer spending, the main driver of the U.S. economy.

The good news is based on the Fed’s comments Wall Street expects QE2 to end in June as planned.  I have previously mentioned that we will likely see a nice pop in the US dollar in the months following the program’s end.  This will reduce the cost of our imports, such as oil, and help relieve some price pressures for us.

As for a third round of quantitative easing, most economists I follow seem to think there is little likelihood it will occur until later in the year if the economy starts to falter.

The Inflation Scenario

The Federal Reserve’s current monetary policy has become rather well known throughout U.S. households by now with “QE1” and “QE2” becoming standard garb from the talking heads on CNBC. However, the consequences of such policy should also be analyzed allowing us to recognize the appropriate avenues of investment to not only seek capital appreciation, but capital preservation.

Quantitative easing (QE) is essentially the act of monetizing debt. The Fed basically prints dollars and then uses those dollars to purchase Treasury debt. Currently, the Fed is the largest purchaser of U.S. debt. With QE2 scheduled to end around June of this year, demand concerns are certainly arising. What buyer will pick up the Treasury purchasing slack to finance U.S. debt? Will they do it at the paltry yields currently being offered?

There is a serious possibility that rates on Treasury bonds will get pushed up by the market in order to find buyers who desire a better yield to hold U.S. debt. This would push the price of bonds down, which provides the better yields.

Remember, when yields rise, existing bonds see their price go down and vice versa.

This scenario would add pressure to the credit markets on a whole providing a rising force on interest rates on a whole, causing an increase in the cost to borrower. Certainly a drag the economy could do without in the future.

However, if we get a rise in overall yields (interest rates) then fixed income investments will become more attractive thus providing better return on our investments in that assets class, assuming you plan to hold until maturity on a bond for instance.

My real concern is as a consumer! Monetizing debt is a task that generally devalues a currency. As the US Dollar weakens the cost of imported goods rises since the currency does not have the same purchasing power it did in the month or quarter before. A specific example is the rising price of crude oil, which most folks recognize when paying higher prices at the gas pump. The following chart shows the rising price action of Light Sweet Crude Oil in 2011, during which time the Fed has been working its QE2 magic. After rolling sideways to start the year, we have seen roughly an 18 percent spike in prices in Q1, with all off that occurring in the last six weeks of the quarter. The Fed has been in full print and purchase mode throughout this period. This notion becomes a bit more clear when you consider that increasing prices are supposed to be caused by increased demand, meaning too many dollars chasing too few goods. The problem with that equation here is that U.S. Oil demand has not increased. The accompanying chart shows that average demand actually fell in 2010 and is flat thus far in 20011. Yet the cost for all energy related goods, such as gasoline and heating oil, has increased.

The positive side of QE2 coming to an end in June is that the U.S. dollar will likely strengthen, helping to atleast NOT promote rising commodity prices. This assumes of course that the Fed’s language doesn’t have the markets thinking QE3 is right around the corner.

This scenario would provide consumers the chance for some price relief on energy and food during the second half of 2011, since imported commodity based items tend to see the largest impacted. In fact, it is those two items that are currently providing inflationary type pressures. Energy costs rose 1.6 percent in February 2011 compared to January, and are up 11 percent year-over-year, according to the Commerce Department’s Consumer Price Index (CPI). The rise in food costs, though not as dramatic, has risen 2.2 percent in February compared to a year ago.

The bottom line is, no matter the outcome, with knowledge we can be prepared to adjust our investment strategies accordingly and even our spending habits if so desired.

I look forward to searching for gold related investments if we do see a spat of inflation, along with analyzing fixed income instruments and the improved yields they will offer if we see interest rates rise. Either scenario, appropriate investments exist to better manage your financial future.

Your hoping the Fed stops the printing press analyst, Mitch Jaworski