Pipeline inflationary pressures are building in the U.S. economy. The "core" Producer Price Index (PPI) for intermediate goods rose at an annualized rate of 9.2% in the three months ended February – the fastest growth since 1995.
The sum of the Institute for Supply Management (ISM) Supplier Deliveries Index and Prices Index averaged 144.5 in the three months ended March – the highest reading since 1995.
The common wisdom is that businesses farther down the production chain will have to "eat" these higher input costs because they cannot pass them
on.
Oh really? If my competitors’ costs are rising along with mine, and my competitors cannot capture market share from me without experiencing even higher input costs and lower profits, then my competitors and I can raise our prices. (An old joke illustrates this point. A customer complains to Smith, the butcher, that Brown, the butcher, is offering hamburger at 50 cents less a pound. Smith replies that when he has no hamburger left to sell, he offers it at 75 cents less a pound.)
It is all the more likely that higher input costs can be passed through if the Fed is willing to accommodate increased credit demand at an unchanged 1% from my customers who may need to borrow more to purchase my higher-priced products.
The longer the Fed refrains from raising the cost of credit, the more rapid will be the rise in some aggregate measure of goods and services prices. So, why doesn’t the Fed begin to preempt a rise in final-sales price inflation now? Perhaps because a rise in interest rates would burst the housing bubble, which, in turn, could inflict devastating damage to the financial system. Oh, there is no housing bubble? Then how do you explain the fact that the price-to-earnings ratio for housing – the index of house prices divided by the index of primary-residence rents – is at a record high?
How do you explain the fact that the value of residential real estate is at a record-high 182% of disposable income?
Heck, no other than Alan Greenspan’s alter ego, Fed Gov. Don Kohn, said on recently "the odds have risen that these [house] prices could be out of line with fundamentals."
With the value of real estate so high relative to household after-tax income, how can housing remain affordable?
This brings us back to the Fed’s current low interest rate policy.
There is a high negative correlation between the Housing Affordability
Index and the level of 30-year mortgage rates. With mortgage rates at multi-decade lows, housing remains quite affordable, despite the sharp rise in home values. What’s love or monetary policy got to do with low 30-year mortgage rates?
So, if the Fed were to act to preempt the rise in final-sales inflation being telegraphed by rising production-input prices, it could do serious harm to the housing market. But to do serious harm to the housing market would mean doing serious harm to the financial system.
The U.S. banking system today has more exposure to the housing market through its holdings of mortgage-related assets than at any other time in the past 52 years. At the end of 2003, mortgage-related assets on the books of U.S. banks, including the direct liabilities of government-sponsored agencies such as Fannie Mae, represented a record 59% of banks’ total earning assets. At the same time, banks’ exposure to the housing market is at a record high, and households have the least relative equity in their homes than at any other time in the past 52 years.
There you have it. If the Fed hikes interest rates now to preempt inflation of goods and services prices, it risks bursting the housing bubble, which, in turn, could do severe harm to the financial system. But if the Fed maintains its current "unnaturally" low interest rate policy, it invites an acceleration in price increases of goods and services, which will necessitate rate hikes down the road, when the housing bubble is even more inflated.
If I were Greenspan, I would retire now to write my memoirs, leaving a note in my desk drawer reading: apr?s mois, le deluge.
Paul L. Kasriel, is director of economic research at Northern Trust Corp. He can be reached at plk1@ntrs.com.
May 28, 2004 Small Business Times, Milwaukee, WI
