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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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July 16, 2013

Commodity Prices and Inflation: The Perspective of Firms

We’ve been thinking a lot about commodity prices lately. In case you haven’t noticed, they’ve been falling. And with inflation already tracking well under the Federal Open Market Committee’s (FOMC) longer-term objective of 2 percent, it’s reasonable to wonder whether the modest downward tilt in commodity prices is likely to put even more, presumably unwanted, disinflation into the pipeline.

We take some comfort from research by Chicago Fed President Charles Evans and coauthor Jonas Fisher, vice president and macroeconomist, also of the Chicago Fed. They conducted a statistical analysis of commodity prices and core inflation and found no meaningful relationship between the two in the post-Volcker era of the Fed. According to the authors,

[I]f commodity and energy prices were to lead to a general expectation of a broader increase in inflation, more substantial policy rate increases would be justified. But assuming there is a generally high degree of central-bank credibility, there is no reason for such expectations to develop—in fact, in the post-Volcker period, there have been no signs that they typically do.

We took this bit of good news to our boss here at the Atlanta Fed, Dennis Lockhart, who hit us with a question we wish we had thought to ask. To paraphrase: Is the response of inflation different for commodity price increases compared to commodity price decreases? The idea here is that, for a time at least, firms will pass commodity price increases on to their customers but simply enjoy higher margins when commodity prices decline.

So we reached out to our business inflation expectations (BIE) survey panel and put the question to them. Of the 209 firms who responded to the survey in July, half were asked how they would likely respond to an unexpected 10 percent increase in the costs of raw materials, and the other half were asked how they would likely respond to an unexpected 10 percent decrease. What we learned was that the boss was on to something.

For the half of the panel given the raw materials cost increase, about 52 percent indicated they would mostly push the materials costs on to their customers in the form of higher prices, compared to only 18 percent who indicated they would decrease their margins. But of the half of our sample that was given a decline in raw materials costs, 43 percent indicated they would mostly take their good fortune in the form of better margins and only 25 percent indicated that the drop in raw materials costs would induce them to drop their prices.

Of course, what a firm thinks it will do and what the marketplace will allow are not necessarily the same. But this got us thinking back to the earlier work at the Chicago Fed. Does this sort of “asymmetric” response to commodity prices appear in the data?

Following (roughly) the procedure that Evans and Fisher used, we computed the influence of a positive “shock” of one standard deviation (about 5 percent) to commodity prices on core inflation. (Our sample runs from 1954 to 2013.) As did Evans and Fisher, we confirmed that commodity price increases had a significant positive influence on core inflation, spread out over a period of several years. But we were surprised to see that when businesses were hit with a similar-sized decrease in commodities prices, the opposite didn’t occur. Commodity price declines did not produce any downward pressure on core inflation.

As in Evans and Fisher, focusing in on just the post-Volcker era (from 1982 forward), we found that the influence of positive commodity price increases on core inflation was significantly diminished (although it appears to be just a little stronger than what they had reported). However, the influence of commodity price decreases on core inflation remained the same—nada.

For many of you, this result probably doesn’t strike you as pathbreaking. There are many macroeconomic models where prices are “sticky” going down but pretty flexible on the way up. But if the question is whether we think the recent slide in commodity prices is likely to put added downward pressure on core inflation, we’re likely to echo Evans and Fisher with a bit more emphasis: the decline in commodity prices isn’t likely to have an influence on core inflation unless it leads to a general expectation of a broader disinflation. And there is no evidence in the data that suggests this is likely—post-Volcker era or not.

Photo of Mike BryanBy Mike Bryan, vice president and senior economist,

Photo of Brent MeyerBrent Meyer, economist, and

Photo of Nicholas ParkerNicholas Parker, senior economic research analyst, all in the Atlanta Fed's research department

July 8, 2013

Let’s Talk about Oil

Given its role in touching nearly every aspect of life across the globe and given the higher and volatile prices over the past half-decade, oil supply has been an incessant topic of conversation for much of our recent memory. Yet the tone of the conversation has dramatically pivoted recently from arguments about whether peak oil or sky-high oil prices could spur a global economic meltdown (anyone remember 2008?) to the shifting energy balance as a result of rapidly growing oil production from North America.

Chip Cummins and Russell Gold recently published a piece in the Wall Street Journal discussing how new supply from U.S. shale oil and Canadian oil sands is helping to steady global oil prices.

Crude prices have remained remarkably stable over the past year in the face of a long list of supply disruptions, from Nigerian oil theft to Syrian civil war to an export standoff between Sudan and South Sudan. The reason in large part is a thick new blanket of North American oil cushioning the markets.

This chart helps demonstrate how quickly the oil landscape in the United States has indeed changed. The U.S. Energy Information Administration (EIA) expects national crude oil production to exceed net oil imports later this year, marking a rapid turnaround from the trend of ever-increasing reliance on imports.

However, despite the increase in U.S. oil production, global oil prices have stabilized at relatively high levels, as the chart below shows.

However, the two seemingly opposing narratives—that of high oil prices and that of an emerging oil and gas abundance—are fundamentally linked. In fact, if it hadn’t been for such high oil prices, this new surge in North American oil production may not have happened. It is much more difficult to rationalize drilling activity in deep offshore areas, hard shale, or tar sands—from which, by nature, oil is expensive to produce—without high oil prices. (West Texas Intermediate, or WTI, oil averaged $31 per barrel in 2003, which, even in real terms, is only about 2/5 of today’s prices.) Analysts at Morgan Stanley estimate that the break-even point for Bakken (North Dakota) crude oil is about $70 per barrel and that even a price of $85 per barrel could squeeze out many of the unconventional producers.

What does all this mean for prices? Well, keep in mind that oil is a global commodity. So the roughly two million barrels of oil per day that have entered the market from the U.S. fracking boom represent a big shift domestically but only just over 2 percent of global oil consumption.

And while the United States is seeing growing oil supplies and moderating demand, a different trend is taking place globally, with rising demand from China and other emerging economies coupled with declining supply from older fields and OPEC efforts to keep prices higher through production limits.

However, not everyone believes that higher prices are here to stay. Some analysts have begun to warn that a price crash may be looming. Paul Stevens, an energy specialist with Chatham House, argues that we may be headed for a replay of the price crash in 1986 when high prices triggered demand destruction while bringing new, more expensive sources of supply to the market from the North Sea and Alaska.

Only time will tell where global oil prices will ultimately shake out, but for now, the larger supply cushion has certainly been a welcome development in the United States. Back to the Wall Street Journal article:

The new supply...is acting as a shock absorber in a global supply chain that pumps 88 million barrels of oil to consumers each day. That helps everyone from manufacturers to motorists, by steadying fuel prices and making budgeting easier.

Photo of Laurel GraefeBy Laurel Graefe, Atlanta Fed REIN director, and

Photo of LRebekah DurhamRebekah Durham, economic policy analysis specialist at the New Orleans Branch of the Atlanta Fed

Authors’ note: We didn’t touch on the difference between WTI and Brent oil prices in this post, despite the fact that the changing global oil production landscape has undoubtedly contributed to that spread. For those interested, we recommend some recent analysis from the Energy Information Administration on the narrowing spread between WTI and Brent.

May 16, 2013

Labor Costs, Inflation Expectations, and the Affordable Care Act: What Businesses Are Telling Us

The Atlanta Fed’s May survey of businesses showed little overall concern about near-term inflation. Year-ahead unit cost expectations averaged 2 percent, down a tenth from April and on par with business inflation expectations at this time last year.

OK, we’re going to guess this observation doesn’t exactly knock you off your chair. But here’s something we’ve been keeping an eye on that you might find interesting. When we ask firms about what role, if any, labor costs are likely to play in their prices over the next 12 months, an increasing proportion have been telling us they see a potential for upward price pressure coming from labor costs (see the chart).

To investigate further, we posed a special question to our Business Inflation Expectations (BIE) panel regarding their expectations for compensation growth over the next 12 months: “Projecting ahead over the next 12 months, by roughly what percentage do you expect your firm’s average compensation per worker (including benefits) to change?”

We got a pretty large range of responses, but on average, firms told us they expect average compensation growth—including benefits—of 2.8 percent. That’s about a percent higher than the average over the past year (as estimated by either the index of compensation per hour or the employment cost index). But a 2.8 percent rise is also about a percentage point below average compensation growth before the recession. We’re included to read the survey as a confirmation that labor markets are improving and expected to improve further over the coming year. But we’re not inclined to interpret the survey data as an indication that the labor market is nearing full employment.

We’ve also been hearing more lately about the potential for the Affordable Care Act (ACA) to have a significant influence on labor costs and, presumably, to provide some upward price pressure. Indeed, several of our panelists commented on their concern about the influence of the ACA when they completed their May BIE survey. So can we tie any of this expected compensation growth to the ACA, a significant share of which is scheduled to go into effect eight months from now?

Because a disproportionate impact from the ACA will fall on firms that employ 50 or more workers, we separated our panel into firms with 50 or more employees, and those employing fewer than 50 workers. What we see is that average expected compensation growth is the same for the bigger employers and smaller employers. Moreover, the big firms in our sample report the same inflation expectation as the smaller firms.

But the data reveal that the bigger firms are a little more uncertain about their unit cost projections for the year ahead. OK, it’s not a big difference, but it is statistically significant. So while their cost and compensation expectations are not yet being affected by the prospect of the ACA, the act might be influencing their uncertainty about those potential costs.

Photo of Mike BryanBy Mike Bryan, vice president and senior economist,

Photo of Brent MeyerBrent Meyer, economist, and

Photo of Nicholas ParkerNicholas Parker, senior economic research analyst, all in the Atlanta Fed’s research department

May 9, 2013

Weighing In on the Recent Discrepancy in the Inflation Statistics

Recently, there has been a divergence between inflation as measured by the Consumer Price Index (CPI) and the preferred inflation measure of the Federal Open Market Committee (FOMC), which is the price index for personal consumption expenditures (PCE). That divergence is fairly evident in the “core” measures of these two price statistics shown in the chart below.

This strikes us (and others, like Reuters’ Pedro da Costa) as a pretty significant development. The core CPI is telling us that the underlying inflation trend is still holding reasonably close to the FOMC’s longer-term target of 2 percent. But the behavior of the core PCE is rather reminiscent of 2010, when the inflation statistics slid to uncomfortably low levels—a contributing factor to the FOMC’s adoption of QE2. Which of these inflation statistics are we to believe?

Part of the divergence between the two inflation measures is due to rents. Rents are rising at a good pace right now, and since it’s pretty clear that the CPI over-weights their influence, we might be inclined to dismiss some part of the CPI’s more elevated signal. But then there are all those “non-market” components that have been pulling the PCE inflation measure lower—and these aren’t in the CPI. These are components of the PCE price index for which there are no clearly observable transaction prices. They include the “cost” of services provided to households by nonprofit organizations, or the benefits households receive that can only be imputed (i.e., that “free” checking account your bank provides if you maintain a high balance.) Since we can’t really observe the price of these things, we’d probably be inclined to dismiss their influence on PCE the inflation measure. But we’ve done the math, and the impact of these two influences accounts for only about a third of the recent gap between the core PCE and the core CPI inflation measures. Most of the disagreement between the two inflation estimates is coming from elsewhere.

We could continue to parse, item by item, all the various components and weights of the two statistics to get to the bottom of this discrepancy. But in the end, such an accounting exercise would merely tell us why the gap between the two measures has emerged, not which measure is giving the best signal of emerging inflation trends.

As an alternative approach, we thought we’d let the data speak for themselves and search for a common trend that runs through the detailed price data. What we have in mind is to compute the “first principal component” of the disaggregated data used to calculate the CPI and the PCE price indexes. The first principal component is a weighting of the data that explains as much of the data variation as possible. So, in effect, the detailed price data in each price index are being reweighted in a way that reveals their most commonly shared trend, and not by their share of consumer expenditure.

The chart below shows the 12-month trend of the first principal component derived from the 45 CPI components used in the computation of the Federal Reserve Bank of Cleveland’s median CPI, and the first principal component derived from the 177 components used in the computation of the Federal Reserve Bank of Dallas’s trimmed-mean PCE. (These are the most detailed component price data we could easily get our hands on.)

So what do we make of this picture? Well, three things:

First, inflation as measured by the PCE price index has tended to track about 0.25 percentage point under inflation as measured by the CPI over time. So part of the gap between the two inflation measures appears to be a long-term feature of the two inflation statistics.

Second, the first principal components of both the CPI and the PCE data have been persistently under their precrisis averages. In the case of the PCE measure, the first principal component is under the FOMC’s 2 percent target (a point that has not gone unnoticed by Paul Krugman).

A third takeaway from the chart is that the “disinflation” pattern traced out by these principal components has been gradual and modest—much more so than what the core PCE has recently indicated and what the data were telling us back in 2010.

Does that mean we should ignore the recent disinflation being exhibited in the core PCE inflation measure? Well, let’s put it this way: If you’re a glass-half-full sort, we’d say that the recent disinflation trend exhibited by the PCE price index doesn’t seem to be “woven” into the detailed price data, and it certainly doesn’t look like what we saw in 2010. But to you glass-half-empty types, we’d also point out that getting the inflation trend up to 2 percent is proving to be a curiously difficult task.

Photo of Mike BryanBy Mike Bryan, vice president and senior economist,

Photo of Pat HigginsPat Higgins, economist,

Photo of Brent MeyerBrent Meyer, economist, and

Photo of Nicholas ParkerNicholas Parker, senior economic research analyst, all in the Atlanta Fed’s research department