Oh Behave! Inflation - NAIRU to the Rescue

Bond guys have always been frowned on for being lovers of bad economic news....doom and gloom actually makes these guys bullish on their market - they're like Dr. Evil. The more people who lose their jobs the happier bond buyers are, unless it's bond market participants being laid off, oops, now there's a touchy subject. But seriously, bond owners receive a fixed payment for extending credit to others, who presumably use that credit to juice up their equity returns, which can increase with the success of their ventures. But the poor bond guy can only earn the coupon he has been promised and get back his principal. He has no upside. Not only that, if the value of money declines through inflation (or exchange rates) the poor bond owner actually sees the purchasing power of his money decline while he clips his coupons and waits for his capital to be returned. But if there is deflation, then he's in the catbird seat so long as it doesn't bankrupt his borrower. The bond owner clips his coupons, which keep going up in value versus everything else, and eventually he gets back his original investment, which has effectively increased by the amount that everything else has deflated over the same period. No wonder bond guys hate inflation and love unemployment. It's hard to have inflation with people being thrown out of work. With lots of workers around, who has the gumption to ask for a higher salary? For those thrown out of work, their consumption goes way down, freeing up goods for others to buy. This causes price increases to stay more contained than they otherwise would be or it might even make them decline. Makes sense to me.

This concept is embodied in an economic theory called NAIRU, which stand for Non-Accelerating Inflation Rate of Unemployment. You can read more about it here. The theory holds that there is a natural rate of unemployment that offers enough of a buffer of labor supply that the economy can grow at its full potential, without igniting an acceleration in inflation. Now the idea that increases in un-employment always have an immediate and direct impact on inflation (as calculated using the "Philips Curve") fell into dispute after the stagflation of the 1970s. But in a way this period actually caused people to rethink the NAIRU theory. It is now more often framed in terms of a relationship between employment and inflation where there is no absolute number below which one will see accelerating inflation, but rather a NAIRU that moves around over time. In an economy that has invested scads of money in labor saving industrial or computing equipment the NAIRU level declines, because productivity helps the economy produce more with more people employed, before wage growth needs to accelerate. In an economy that has strong unions, little investment in labor saving technology or capital equipment and cost of living adjustments (COLA) baked into the wage structure etc (as the US did in the 70s) the NAIRU level of unemployment is much higher. You have to throw lots of people out of work before expectations of future wage gains get squashed. This time NAIRU may have climbed for a different reason: growth in demand for commodities, outside the U.S.

So where are we now?

As you can see from the chart below, CPI is up significantly from the low of 1.069% year to year growth in June 2002, to the June figure of 4.901%. However, CPI is not really all that much higher than at the last economic peak of July 2000, when it was running 3.599%. Now we all know these numbers are junky and that the impact of price increases on our daily lives are much greater right now....but we will touch on this factor later.

Courtesy of Guild Partners

Note that unemployment bottomed at about 3.9% during the dot com boom, but never got quite that low during the housing boom. It troughed this time at 4.4% in March of 2007. In both cases the Fed got nervous about how low unemployment could go without sparking inflation (NAIRU). As is usually the case, the end of the recent boom was brought on by Fed rate hikes, which usually precipitate the upturn in unemployment, as the Fed engineers a slowdown or recession.

Courtesy of Guild Partners

The impact of rising unemployment on consumer price inflation during the dot com boom/bust cycle is quite vivid from the chart below. Now this is only one cycle, but I think you get the logic here and you can see the correlation. We don't have the July CPI number yet, so we can't see how it compares with the 5.7% unemployment just registered, which is the highest since December 2003. Please note that as Noah has described on Urban Digs before, the screwy seasonal adjustments the government makes means that recent inflation has thus far been under-reported in the headline numbers and will start to surge this summer as the funny stuff reverses. I believe that this time things will be slightly different in terms of unemployment's impact on inflation as much of the inflation we are seeing is beyond our control. For one, much of the inflation has been based on commodity price inflation, specifically energy-related commodity inflation - which now includes agricultural product inflation courtesy of the geniuses who brought you ethanol (food as fuel) subsidization. Also, the inflation pick up has been accompanied by and/or caused by a weak dollar. For this reason many feel that the inflation we are now seeing is completely out of the control of the Fed in that the higher interest rates needed to stabilize the dollar and quell inflation would send the economy into a depression.

Courtesy of Guild Partners

So let's talk about these two issues. On the commodity inflation side let's not forget the surge in metals like copper and steel as well as some construction materials like lumber that has occurred in addition to the energy spike. These commodities give us a bit of a laboratory to look at commodities that have been impacted by domestic demand and those that haven't. Check out this chart of copper (they call it Dr. Copper because it has an honorary economics degree). It is supposed to be a strong predictor of economic growth.

As you can see, copper, which is consumed all over the world and particularly in China, as they build out housing and their electrical grid, hit a peak in 2006. The big move that year was actually driven by a rogue trader in China who was caught massively short. (Note to traders: always get out/get short on the blow-off rally that results when someone else gets squeezed to death). It took copper a couple more years to make a nominal new high. It's still a bullish chart and commodity, but it really has not contributed to "inflation" for a couple of years. But it didn't fall out of bed, despite the fact that a lot of copper is used in construction of single family homes and the housing bust has trimmed US demand from this source. In contrast, take a look at lumber prices.

Lumber prices should be called US & Canadian lumber prices, as it is a largely domestic market, because it doesn't really pay to ship lumber around the world. See how lumber peaked, even before the housing market, probably just as the largest number of new homes were being framed out for sale in 2005. Now these commodities have their own supply demand stories, but they give you a feel for the fact that some can really be influenced by the US economy, while others are more global. Let's face it, the world has never been more global, so lack of US consumer demand for stuff, despite it being 30% of the total demand, doesn't automatically or immediately relieve price pressure on a global basis. However, when things get too expensive, it does kill demand. We have seen demand killing by gasoline prices for the last few months and oil prices have gotten hit pretty quickly. So while I think there will be a lag between unemployment rising in the US and a drop off in inflation, this time, I don't think the rules have been rewritten. Couple the increasing unemployment with a slowdown in foreign economies, which is causing the dollar to firm, and you can see where commodity inflation could start to fade. In order for this somewhat rosy scenario to play out, foreign economies must continue to slow, without US employment falling off a cliff by itself. This will be helped by US demand for overseas goods declining, while our exports continue to grow.

Bob Barbera is an economist whose work I used to read religiously. He has an amazing ability to point out the obvious, importantly it is usually only obvious to him because he actually does the work to scrub down economic numbers and see what they are really saying. In a recent piece that a friend forwarded me he opines "if it were not for improving net exports, U.S. output would have declined over the past three quarters. Deconstruct that contribution and you find that the big story is not booming exports - they rose at a 9% pace last quarter, equaling their growth rate over the previous two and a half years. The news is embedded in the import line. Real imports fell at an astounding 7% annualized rate. He goes on to mention that "Quite amazingly, average hourly earnings in July climbed only 3.4%, year-over-year, compared to a 4% year-on-year rise over the year ending in July of 2007. That is amazing because headline inflation rose by nearly 5% over the period. To what does the Fed owe this good fortune? Over the same period the jobless rate leapt, climbing to 5.7% from 4.7% one year back. Relax President Plosser, the leap for joblessness is keeping wages in check." Bob avers that the lack of wage inflation coupled with energy inflation is squeezing the purchasing power of U.S. households as never before.

So I find myself at least somewhat on the side of those bond market baddies playing Dr. Evil. Bring the unemployment.....just not too far or too fast and I'll be looking on happily....wearing my Nairu jacket of course.

• Add to del.icio.us
• Digg this!
• Add to Technorati
• Add to Reddit