Markets Should Prepare for Higher Inflation, Interest Rates

Commodity prices have been surging in recent months. In 2010, the global Commodity Price Index for fuel (energy) climbed 21%, for food 27% and for industrial inputs, including raw materials and metal, a whopping 31%. Yet headline inflation and core prices, excluding food and energy in the United States, have been tame, up just 1.1% and 0.8%, respectively. And in November the Fed was worried about deflation. So, where does the disconnect lie?

The answer has at least five major components: flat wages, falling to flat cost of housing, low velocity of capital, the relationship of the dollar to other currencies, and the globalization of manufacturing and its impact on pricing power. Thus far, trends in these areas have greatly offset the strong increases in commodity prices. Two of the most important drivers of inflation in the United States are the cost of housing and wages, both of which have declined or remained stagnant. The housing component is calculated by estimating an owner’s cost of renting his/her house, which has been particularly weak compared to apartment rents. In the past six months, the U.S. dollar has climbed by 14% over the Euro, reducing the domestic impact of recent global commodity price increases. In the past 12 months, productivity per hour worked among U.S. employees increased by 2.5%, enabling firms to produce more without having to hire and keeping wage pressure low due to the high unemployment rate. Year-over-year growth in total compensation costs, which includes wages and benefits, has been tepid, up a mere 1.9%. Furthermore, companies have found that they cannot increase prices, with wage growth so low and unemployment so high. Intense competition on finished goods is also keeping a lid on pricing thanks to globalization of manufacturing. Another major factor is the low velocity of capital despite massive liquidity infusion around the world and low interest rates. Weak demand for consumer and business loans has prevented inflationary pressure so far in the recovery.