Weekly Economic and Financial Commentary

Inflation Is Heating Up

Mon, Nov 19 2007, 06:44 GMT
by Wachovia Research Team - Wells Fargo Investments, LLC | View company's profile

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Inflation Is Heating Up

Although October's inflation reports were close to expectations, the year-to-year change in both the Producer and Consumer Price Index increased significantly. The culprit is soaring oil prices and the delayed, but significant, hike in gasoline prices. On a year-to-year basis, the overall PPI is now up 6.1 percent, while the CPI is up 3.5 percent.

The run-up in the headline inflation will almost certainly get worse before it gets better. In October, gasoline prices were relatively flat in the real world. However, gasoline prices usually fall in October, thus on a seasonally adjusted basis, prices rose more than one percent. Gains of this type are quirks and typically do not produce much follow through to prices elsewhere.

November also usually sees a decline in gasoline prices, reflecting a seasonal slowdown in demand. This year, however, prices have soared, rising by about 10 cents a gallon in just the past week. The rise in gasoline prices, at a time they should be falling, will produce an outsized gain in the November CPI and send the year-to-year change back above four percent.

Retailers Are Nervous Going Into The Holiday Season

Actual price increases in gasoline are also much more likely to be passed through to prices of other goods and services than a smaller than usual drop in prices. So we will also likely see some additional pick up in the core inflation measures. The core CPI rose 0.2 percent in October and the year-to-year change has risen to 2.2 percent.

Higher gasoline prices also give retailers one more thing to worry about this holiday season. October retail sales were generally lackluster. Overall retail sales rose 0.2 percent in October and sales excluding gas and motor vehicles rose just 0.1 percent. In light of the weak October numbers, retailers have expressed a great deal of caution about the upcoming shopping season. Macy's and J.C. Penny reduced their expectations for holiday season sales.

While economic challenges, including higher energy prices and the widely publicized housing woes, get most of the attention, retailers are also having to deal with warmer than usual weather and the lack of any must-have items this holiday season. Flat panel televisions, video games, high definition DVD players, iPods and other personal music devices will all be popular gifts this year. Prices for all of these items have fallen sharply over the past year, which will make it difficult for retailers to post large sales gains, even if they sell a lot more merchandise.

The growing caution by retailers has some real implications for the rest of the economy. Diminished sales expectations have caused retailers to order more cautiously and most chains are running unusually lean. The lack of inventory building is one reason imports grew so slowly in the third quarter, contributing to the surprising narrowing in the trade deficit. Even modest sales growth will likely produce a smaller inventory gain in the current quarter, which will cut into overall GDP growth.

If retailers stocked their stores with fewer goods this holiday season, they will also likely hire fewer seasonal workers. The net result could be a surprisingly weak nonfarm employment report for both November and December.

While warmer than usual temperatures would likely dampen holiday spending, they would also produce some net benefits. Home heating costs have increased dramatically this year, particularly for those heating with fuel oil. If temperatures stay warm, utility use will be down and that means the personal consumption deflator, which is the Fed's preferred inflation gauge, will not show as much upward pressure as the more widely followed consumer price index.

Global Review

Data released this week showed that growth in some major foreign economies strengthened in the third quarter from the pace that had been registered during the preceding quarter. As shown in the chart at the left, the annualized rate of real GDP growth in the Euro-zone rose from 1.3 percent in the second quarter to 2.8 percent in the third quarter.

A breakdown of real GDP in the broad Euro-zone into its underlying demand components will not be available for another two weeks, so we can only surmise the drivers of growth in the third quarter. Capital spending, which has consistently made positive contributions to real GDP growth for the past three years, probably rose further in the third quarter. Indeed, “hard” data from France showed that investment spending rose 2.7 percent, and German statistical authorities said that capex was one of the primary drivers of German

GDP growth. The exact amount won’t be known until next week. Although consumption expenditures in France rose at a very robust rate of 4.2 percent, growth in real consumer spending in the broader Euro-zone likely grew at a more modest pace. Inventories may also have made a positive contribution to overall GDP growth, which sets the stage for slower overall GDP growth in the current quarter. Indeed, the ZEW index of German investor sentiment in November fell to its lowest level since early 1993 when the economy was in recession (see top chart). The decline in the ZEW index suggests that the Ifo index of German business sentiment, which is highly correlated with industrial production growth, dropped further this month.

The respectable growth outturn should reinforce the notion at the European Central Bank that the economy does not need lower interest rates. Indeed, CPI inflation data for October could convince some ECB policymakers that higher rates are needed to keep inflationary pressures in check. As shown in the middle chart, the year-over-year rate of CPI inflation shot up to 2.5 percent in October, well above the 2 percent rate that the ECB considers to be “price stability.” However, the core CPI inflation rate remained at 1.9 percent, which should make the perceived need for a rate hike less urgent. Indeed, we believe that prospects for slower growth going forward will keep the ECB on hold for the foreseeable future.

Japanese real GDP, which declined at an annualized rate of 1.6 percent in the second quarter, rebounded 2.6 percent last quarter (see bottom chart). Although net exports contributed 1.6 percentage points to the overall GDP growth rate, real consumer spending rose 1.3 percent, and private non-residential investment grew at a respectable pace of 7.1 percent.

Looking forward, we project that the Japanese economy will continue to grow, albeit at a fairly modest rate. As noted above, real consumer spending rose in the third quarter, albeit at a sluggish pace. Until Japanese consumers become less hesitant to open their wallets, the outlook for overall economic growth will be somewhat muted. In addition, slower global growth in the quarters ahead should lead to less external stimulus to the Japanese economy. The bottom line is that Japanese interest rates should remain very low for the foreseeable future.

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Published On Mon, Nov 19 2007, 06:53 GMT

About this Report

Wells Fargo Investments, LLC

https://www.wellsfargo.com/

sam.bullard@wachovia.com

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