Inflation Pressure Might Get Nasty

As consumers, we have entered a very difficult period in our lives now that many of the emerging markets are growing up and entering first-world status. The wave of  people entering the middle class has created exponential demand for a better way of life, putting huge upside pressure on prices for just about every good and service we use.

When China entered the World Trade Organization in 2001, it was the sea change that kick-started this whole commodity boom that, until just recently, has shown a steady and relentless uptrend for food and energy prices — two of the most important components of any household budget.

The latest data on inflation released at the end of 2011 shows a disturbing trend that’s being talked down by the Fed because of slowing consumer demand for housing. But the data is revealing about the threat of inflation — and how real that threat is:

• Producer prices rose 4.8% year over year for 2011.
• Core CPI is up 2.5% year-over-year for 2011, but it’s up 3.6% in the past six months.
• The outlook for commodity prices remains highly uncertain and is the key factor in the inflation outlook at this time.

Producers have done a masterful job of not passing on many of the raw materials price increases, but those margins of safety are rapidly narrowing, and price increases for finished products eventually must be incorporated in the final demand equation if businesses expect to show profits.

Just look at how the airline industry has remade itself in the past two years, with passengers expected to pay for most everything — even water. Despite the efforts of goods producers to keep prices down in a soft economy, inflation at the consumer level is alive and well.

• Energy and food prices were the drivers of total CPI, as food accounts for 14.9% of the index, and energy 9.7%.

The danger of higher oil prices rising is that it feeds down through the supply chain into businesses. Everything that requires a transport to get a good or service to market will feel the need to pass that cost on to consumers. Higher oil prices will be a big concern going forward.

Do you remember when President Richard Nixon imposed emergency wage and price controls on the economy? He took that extraordinary measure because, in August 1971, inflation was seen as a national crisis. The prices of everything consumers were buying were spinning out of control. Here’s the kicker: The inflation rate then was a mere 4.4%, based on the Consumer Price Index.

So why aren’t people going nuts now? Maybe it’s because back in August 1971, the American public was used to inflation, so 4.4% wasn’t really a shocker. But today, we still remember the hyper-inflation that peaked in 1980 at more than 14%. In that context, maybe a 3.5% rate is considered manageable.

But don’t get trapped into thinking 3.5% is nominal. The yield on a 10-year Treasury bond is now about 1.95%. That nominal 3.5% inflation reduces your real interest income by about 10% of the effective yield, meaning that if you’re earning a 10% dividend yield, the effect of 3.5% inflation reduces that effective yield to 9%. If you’re invested in 10-year Treasuries, your effective yield is about 0.5%. It’s a meaningful hit, and unless your wages or retirement income is increasing by 3.5% to offset that haircut in yield, you’re facing a growing dilemma.

But hey! Fed Chair Ben Bernanke is now touting that the demand destruction in the United States created by the spike in energy prices and the deterioration in home values will curb future inflationary pressures, and he says we don’t have to worry.