Price check

Larry Kudlow
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Posted: May 13, 2004 12:00 AM

 A surprising new economic report suggests that the U.S. manufacturing sector is operating at or near full capacity. This raises threatening red flags about Federal Reserve interest-rate policy and higher future inflation.

 According to Economy.com, the Institute for Supply Managers' biannual outlook shows manufacturing capacity utilization at 85.6 percent. This is way above the Fed's current estimate of 74.6 percent and could be a strong signal that more inflation is coming. (Economist Bruce Bartlett deserves thanks for alerting the profession to this report.)

 Economy.com believes the difference between these numbers may lie in the fact that the Fed does not remove "dead" capacity nearly as quickly as the real-world ISM poll. "Capacity presumably 'died' at a faster pace during the deep investment recession of the past few years," stated the economics website.

 This helps explain the moonshot reading of 88 percent on the ISM price index for April. Near bottleneck factory conditions combined with globally driven oversized order books is a sure formula for big price hikes. The last time the ISM price index was this high was back in November 1979 -- the dark old days of stagflation. 

 For April, 77 percent of supply executives reported paying higher prices, while only 1 percent said prices were lower. (Twenty-two percent said prices were unchanged.) Across-the-board price hikes were reported on furniture, energy, wood, transportation, textiles, metals, chemicals, apparel and many other items.

 The year-to-date producer price index, which tracks the prices of wholesale business goods, is 5.1 percent at an annual rate, or 2.1 percent on a core basis (excluding food and energy). If the ISM capacity numbers are right and the Fed is wrong, then the PPI is going to accelerate markedly over the remainder of the year, as industrial demands outstrip production capacity.

 There is no automatic pass-through from the producer price index to the consumer price index, which is where inflation meets Main Street. However, through March, the CPI has also increased at a 5.1 percent annual rate, with a core reading of 2.9 percent. Many economists have held that the Fed will act much more aggressively if core inflation readings exceed 2 percent. Well, we may already be there. 

 The stock market, of course, is smarter than the Fed and all the rest of us put together. The recent big sell-offs may be discounting a tougher-than-expected 2004 (in terms of inflation and interest rates).

 Ultimately, all these price movements are driven by excess liquidity supplied by the central bank in relation to the availability of goods in the economy. Inflation is always a monetary problem. Push in too much money to chase too few goods, and prices everywhere start rising.

 Inflation-sensitive market-price signals have been warning of excess liquidity for at least a year. Gold and commodity prices have recently nosedived in market trading, but that's after a huge run-up in the prior 18 months. Meanwhile, sinking bond prices and rising yields, along with a steeply upward-sloping Treasury yield curve (an unusually wide gap between bond rates and the overnight rate on the fed funds policy target), continue to signal excess money and future inflation.

 Taken together, too much liquidity in the economy, tighter capacity use in manufacturing, an energy-price spike and unbelievably strong raw-material demands from China have set the stage for an inflation comeback.

 Offsetting these inflationary factors, lower tax rates, record productivity and more-rapid economic growth are now working to create a greater-than-usual supply of new goods and services. This positive supply shock, driven in particular by tax cuts, will absorb some of the excess money in circulation. That's why the mere expectation of Fed rate hikes and money-withdrawing actions has led to a recent drop in gold and commodity prices. This may suggest that the inflationary potential in the economy is more muted than price pessimists believe.

 Nonetheless, Greenspan & Co. have incorrectly focused on lagging indicators of inflation, an approach that seems to have put them behind the curve for maintaining domestic price stability. The Fed's much-ballyhooed "output gap" difference between actual and potential gross domestic product, along with unit labor costs and mismeasured capacity use, are backward-looking and non-monetary signs of inflation.

 Many supply-siders instead advocate a price-rule approach: the use of forward-looking market prices rather than backward-looking government data to track early warning inflation signs. For this reason, price-rulers have correctly warned of the monetary-based inflation threat. Today they have every reason to be concerned that the Fed has waited too long to rein in unusually easy money.

 Ever try to drive a car through the rearview mirror? It's a dangerous stunt. Aiming forward through the windshield is the much safer bet. Hopefully the Fed will learn this before they drive economic recovery off the road.