CPI

The flow of weak data continued this morning and leaves us all with plenty to ponder over the weekend: the economy may well be headed out of recession as inventories are adjusted, but beyond that the horizon is murky to say the least.

The theme all week has been the abrupt ebbing of forward momentum and today’s news that consumer confidence fell in July – the index dropped to 63.2 from 66.0 – merely reinforces a worrying trend. The consensus prediction among analysts had been that the index would rise to 69.0, so obviously plenty of people have been carried away by the hoopla over recovery rather than getting a solid read on the underlying factors affecting consumers.

Wall Street analysts are perennially optimistic and tend to see a bright future on the basis of the slightest break in the clouds. This is what has happened over the past two months. As all the data started to suggest that the economy was no longer in free fall Wall Street immediately rushed to the conclusion that it would adjust back to normal quite quickly. Hence the run up in stock prices that seem to be based upon profit projections unrelated to where business is today.

I would urge caution.

While it is very clear that the economy has started to level off and is no longer imploding at the rate it was last year, we remain very far from a sustainable recovery. On the contrary the turn around has all the makings of being a ‘technicality’ rather than a ‘reality’.

Consumers seem to agree.

Dark clouds are hanging heavily over consumers: unemployment is the leading issue, and there seems to be no prospect of job generation in the next few months. Home prices are devastated which has destroyed many people’s savings – home equity is a false measure of ‘savings’ but many families fell into the trap of believing it was secure. And even those who are still employed are facing shorter work weeks, lost benefits, and reduced wages. This is not a recipe for rapid recovery. Indeed it may not support recovery at all.

Prices reflect this weak activity.

The Consumer Price Index was flat month on month in July, which was about what everyone had expected. Food and energy prices fell sufficiently to offset increases elsewhere, especially in health care costs. Unfortunately the CPI has now fallen 2.1% since this time last year, which, while not unusual in a recession, is not a trend we want sustained for long: the threat of prolonged deflation is too damaging to be viewed without alarm.

The enormous slack in the economy provides businesses with no room for price increases; commodities are generally in good supply relative to the now low levels of demand and so their prices are not under great pressure; and labor costs are still falling. All of which suggests that prices will be quiescent for a while longer.

Overall I doubt inflation is a concern any time soon – until well into next year. This is despite the huge flood of money that the Fed has pumped into the economy over the past year. Most of that extra cash is now sitting as excess reserves held by banks at the Fed – it hasn’t found its way into the economy by way of credit growth. As long as that cash sits in the vault it represents no threat of inflation. But nor does it help us re-ignite growth. The Fed’s dilemma next year, or maybe in 2011, will be how to suck that cash out of the economy so as to prevent sudden uptick in prices.

You will read plenty of panicky stories in the financial press about the risk of inflation stemming from the enormously lax Fed monetary policies of the last year – pay them little or no heed. The people who are now worried about inflationary expectations driving up long term interest rates are ‘fiscal hawks’ – they are not focused on the depth to which the economy has plunged and the gap that has now opened up between actual activity and potential activity. My advice is to focus on that gap: until we have worked off the slack in the economy, that is until factories are humming, jobs are abundant, and workers are hard to find because they are all employed, inflation will be a theoretical rather than actual threat. Over a five year horizon I see rising inflation along with rising taxes to rein in fiscal deficits. Over the next two years though I don’t see inflation as much of an issue – not yet anyway.

So the week ends on a weak note. The optimists still cling to a vision of a recovery sufficiently robust that it self-sustains and thence accelerates. My view is that the recovery is less secure: until consumers are a firm footing with debts well covered, jobs safe, and wages growing, the economic engine will continue to sputter. As I reported yesterday: the entire GDP growth later this year can be attributed to the effects of the stimulus and an inventory correction. This means that the private sector is falling well short of the kinds of activity we need for a sustainable recovery to emerge.

This really does have all the makings of a jobless recoveryso we may well need more stimulus this fall.

The prospect for that is not good. Let’s hope that the next few weeks brings a turn about in consumer sentiment. Then we can look forward to 2010 with more optimism.

Addendum:

A brighter note:

Today’s release of real incomes shows a slight uptick in weekly wages from June to July. The growth came entirely from longer work hours as factories increased output to restore inventories. This is exactly the kind of impetus that the more optimistic analysts use when they forecast a self-sustaining recovery taking hold later this year. This evidence supports their case, let’s hope it continues.

More interesting in today’s report is the fact that wages increased 0.1% from July 2008 to July 2009. This looks very poor until we factor in the drop in CPI I mentioned above. Take the two together in order to arrive at inflation adjusted incomes, and real wages – which in theory are the measure we should be looking at – rose a decent 3.5% [ don’t add the CPI to the wage growth number: there is a separate CPI-W for wages, which deflated a little more than the overall number!] . This provides some extra hope that consumers will start to feel better about the future.