Here is a follow-up on one aspect of the latest Philly Fed's Business Outlook Survey, which I reported on last week.
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, which is current through March. The other is an indicator constructed from two data series in the Philadelphia Fed's Business Outlook Survey. It is the spread between the Philly Fed's prices paid (input costs) and received (prices charged) data.
A major risk factor for margin squeeze had been the increase in commodity prices over the past several months with the price of oil and gasoline as the dominant factor. Energy prices had fallen dramatically since their interim highs around the end of February, but the trend in energy costs has reversed during the past several weeks and is showing some evidence in the September data.
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 latest ratio is at the 94th percentile of the 793 data points in this series, down from the 96th percentile last month. The interim high since the 2008 peak was the 99th percentile in April of 2011, but on a percentile basis, the ratio had essentially stalled in the mid 90th percentiles since August of last year, hovering between the 93rd and 96th percentiles.
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. The volatility is so great that the value for any specific month can't be taken very seriously. However, 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 latest monthly ratio is at the 20th percentile of the 540 data points in this series, up from the 15th percentile last month. The 12-month MA is now at the 13th percentile.
By official government metrics, the CPI and PCE, inflation is not a near-term threat. The Federal Reserve has worked hard following the Financial Crisis to raise the level of core inflation. However, their success in 2011 and 2012 has been slipping over the past several months. Note that the Fed uses the PCE core index as their favored metric, which has fallen to 1.26%.
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 unemployment number from the Bureau of Labor Statistics is 7.6%. Also, U.S. demographics today 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 67, 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, volatility 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. In fact, there are some in the economic analysis community who see deflation as a more ominous threat.
On the other hand, the volatility of commodity prices, keeps the threat of profit margin squeeze on the list of potential dangers.