May 19, 2011
The two charts below offer clues for evaluating the risk of profit margin squeeze in the current economy. One is the ratio of crude to finished goods in the Producer Price Index (data through April). The other is an indicator constructed from two data series in the Philadelphia Fed’s Business Outlook Survey through today’s release. It is the spread between the Philly Fed’s prices paid (input costs) and received (prices charged) data.
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A major risk factor for margin squeeze is the increase in commodity prices over the past several months with the price of oil and gasoline as the dominant factor.
So let’s take a broader view of these two indicators by viewing them within the context of inflation as measured by the Consumer Price Index. As the first chart clearly shows, the all-time high in the PPI crude-to-finished-goods ratio was in July 2008, the same month that crude oil and gasoline prices in the U.S. hit their all-time highs. The previous ratio high was in the summer of 1973, a few months before the outbreak of the October Arab-Israeli War and the Oil Embargo. Inflation had already been rising in a series of waves since the mid-1960s. But Middle-East events of 1973 were the primary trigger for the nearly ten years of stagflation that followed.
The April 2011 ratio rose to the 99th percentile of the 769 data points in this series. That’s the highest level since September 2008, the tail-end of a ten-month spike that peaked during the summer of that year.
The Philly Fed Prices Paid Minus Prices Received Index is an extremely volatile series, which I’ve illustrated by using dots for the monthly data points. To highlight the underlying pattern, I’ve included a 12-month moving average (MA). The date callouts show that the comparable levels in the past were associated with inflationary peaks. The April ratio is down from last month but remains high: at the 88th percentile of the 517 monthly data points in this series. The 12-month MA has declined 2.1% from the all-time high set in March.
By official government metrics, the CPI and PCE, inflation is not a near-term threat. In fact, the Federal Reserve has been working hard to raise the level of core inflation.
Of course, there are many differences between the inflationary decade of the 1970s and the present, not least of which is the rate of unemployment. In August 1973 (first chart above), unemployment was at 4.8%. The latest Gallup Poll unemployment survey puts the mid-May rate at 9.2%, slightly above the 9.0% April number from the Bureau of Labor Statistics. Also, U.S. demographics are quite different. The oldest Boomers were turning 27 in 1973. They were at the beginning of their careers with decades of wage increases in their expectations. This year they are turning 65, and many are already on Social Security as their main source of income.
At present, in light of the unemployment rate and the ongoing demographic shift, the rise in commodity prices probably poses more risk of continuing margin squeeze than run-away inflation. Some degree of cost-push inflation may be a near-term risk, but the demand-pull inflation we saw in the 1970s is difficult to envision in the U.S. economy of this decade.
On the other hand, the decline in many commodity prices, especially oil, over the past few weeks may eventually reduce the risk of margin squeeze. But with summer on the way, a seasonal rise in gasoline prices would likely keep the squeeze in play.
The next Philly Fed Business Outlook Survey will be released on June 16, 2011.