United States: No Room for Error on Inflation

The inflation outlook has become more clouded in the wake of hurricanes Katrina and Rita, and Global Insight has lifted the forecast for headline inflation in recognition of the price effects already apparent. That said, Global Insight continues to see headline inflation peaking this year. CPI inflation is now projected to hit 3.5% in 2005, which would be its fastest rate of increase since 1991. But as Gulf of Mexico energy production is brought back on-line, energy prices should retreat, pulling CPI inflation down to 2.7% in 2006.

Apart from lower energy prices, the projected unwinding in inflation stems from Global Insight’s belief that the past two years have represented the start of a traditional demand-driven commodity price cycle. As demand growth slows and, more importantly, capacity is added, markets should move toward a better balance.

Before the hurricanes, this supply-side adjustment was underway, with the pressure in supply chains beginning to abate. Data to August from the Institute of Supply Management (ISM) show that growth in both order backlogs and supplier delivery times had been slowing for some time, a sign that businesses were removing bottlenecks. More specifically, raw materials prices had been softening. The core crude materials PPI, for instance, fell in seven of the nine months to July. Other broad non-oil measures of raw materials prices had been showing similar weakness.

The problem is that the hurricanes disrupt this adjustment process, hitting the energy industry hardest—the sector most strained by rising global demand over the past two years. ISM September data highlight this. In no surprise, the price component of both the manufacturing and nonmanufacturing indexes surged. But orders, order backlogs, and supplier delivery times followed very different paths. The manufacturing indexes showed uniformly large gains. The nonmanufacturing orders and order backlog indexes fell sharply, with the supplier delivery index registering a small increase. For goods producers, the hurricanes appear to have caused purchasing managers to look outside their base of suppliers in an attempt to mitigate possible disruptions in their supply chains. For nonmanufacturing firms, which include utilities and logistics providers, the hurricanes caused more damage.

To date, the economy has proved to be remarkably resilient in the face of higher energy prices. The rise in crude prices from $30 to $55 per barrel pushed up core CPI inflation from under 1.5% at the start of 2004 to just over 2.0% today, a rate of increase that moves to the upper end of the Federal Reserve’s comfort range.

Even before the hurricanes, the economy was looking to absorb a further $10/barrel rise in oil prices. The question now is how much of this latest shock will bleed downstream into consumer prices.

It is certain that inflation will spike during the next few months, with the increase in the CPI running at an annual rate near 5.0% in the fourth quarter. Annualized finished goods inflation is now projected to rise more than 16.0% in the fourth quarter, its fastest rate in more than 25 years.

Some additional upward pressure on core inflation must be expected, given the magnitude of the jump in energy prices. The longer gasoline prices stay above $2.50/gallon and natural gas above $10 per million Btu, the more likely there will be a damaging upward revision in inflation expectations, which to date have remained remarkably well anchored.

Given that very high energy prices will not disappear quickly, Global Insight projects core CPI inflation will continue to drift higher, on an annual basis going from 1.8% in 2004 to 2.5% in 2006. On the positive side, we believe core inflation will hold at this higher rate.

While forecasted core inflation remains contained, it will now be at the very top end of the Fed’s desired range. The hurricanes, by propelling inflation slightly higher, leave the Fed with no margin for error and place the attendant risk in the inflation outlook squarely on the upside. Not an enviable position for Chairman Greenspan’s successor.