Why the Fed can’t Control Tomorrow’s Inflation

The Federal Reserve is pulling out all stops to fight deflation, but it is not clear that deflation is even a plausible risk. It is even less clear that the Fed can control some of the key factors that will determine the US inflation rate.

In the US, economic debate often focuses on the consumer to the exclusion of everything else. From this perspective it makes sense to assume that low interest rates promote high inflation (consumer buys more on credit and drives up prices), and high interest rates cause low or now inflation. There is some truth to this, but the real world is not driven exclusively by shopper preference.

There are costs associated with making, transporting, and selling things. Any company that wants to stay in business needs to sell their good and services for more than it costs to produce them. The cost of consumer goods is determined by two main factors: the cost of raw materials needed to make them and the cost of labor.

Commodity indices are a good proxy for the cost of raw materials. The chart at right shows one such index over the last 40 years.

From 1970 to the early 2000s, overall prices did not change in any material way (Bad news for people who think commodities are an investment.). At some point in 2002 or 2003 this changed and commodity prices skyrocketed. The big spike in 2008 is due to the oil miniature bubble and subsequent collapse, but the general up-trend is present in all commodity prices.

The material cost of making things has gone up about threefold since 2000. In contrast, consumer prices in the US rose less than 30% over the last decade.

How is this possible?

One factor is that rising commodity costs have been offset by shifting manufacturing jobs to low-wage countries. This cannot compensate for rising material costs forever. Manufacturing jobs are a finite resource. Once the last one is outsourced, labor costs cannot easily be lowered further, and raw material prices will exert more pressure on consumer prices.

The other factor is that the growing demand for cheap labor is driving up labor costs in China and elsewhere. These sources of cheap labor will not remain cheap forever. From a cost perspective this may be manageable by re-outsourcing manufacturing from China to some other newly emergent economy. However, it is likely that those new cheap labor pools won’t be quite as cheap as China once was, because China and India will be competing to outsource their manufacturing to these countries too.

US interest rates don’t affect these factors directly, which puts them mostly out of Fed’s control. Even if the Fed manages to keep their homegrown inflation under control, these external factors are likely to push up consumer prices. In the more likely case that the Fed has some trouble putting the inflation genie back into its bottle, consumer prices could rise sharply over the next five to ten years.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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