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Tuesday, 19 August 2008

Bracing for Inflation

By John K. Castle

Growing evidence suggests American consumers, businesspeople, and political leaders should all be bracing for double-digit inflation, probably as early as 2009.

The relative price stability of the past 15 years is giving way to worsening inflation, despite the recent softening of oil prices. The Consumer Price Index for all items shows the inflation rate averaged 2.6% a year from 1992 through 2007 but has doubled since January, reaching an annual rate of 5.6% in July (BusinessWeek.com, 8/14/08). By next year, the monthly figure could hit double digits, and the inflation rate for 2009 overall could triple 2007's 2.85%.

I say this not only because I have looked at a broad range of statistics that point in this direction. I also run a private equity investment firm that owns companies in a number of industries -- including restaurants, the manufacture of gardening tools, oil and gas exploration services, and distribution of entertainment products such as books and videos -- that are already being forced to pass price increases on to the consumer.

The skyrocketing price of oil is obviously a central element in the accelerating price spiral. But a sea change in China's role (BusinessWeek, 6/19/08) is beginning to have a huge impact as well.

Increasing Commodities Pricing

Anyone who hasn't been living in a cave for the past year knows that oil prices have soared and pushed up the prices of gasoline, diesel fuel, and heating oil. Largely hidden from view, however, have been steep and continuing price increases across the whole spectrum of commodities.

Oil almost doubled in price, from $78.21 in July 2007 for a barrel of benchmark crude, to $145, where it peaked before dipping below $120. But from a longer perspective, oil sold for about $30 a barrel during 2003 and much of 2004. Thus it has actually quadrupled in five years. Coal, traditionally volatile, sold for about $30 a ton during 2003, peaked briefly at $63 in 2004, and went for $45.25 at the end of July 2007. A year later it hit $139.50 before slipping back a bit. It has tripled in 12 months.

Copper, another basic commodity, went from 82% a pound in July 2003 to $1.14 a year later, and to $3.72 by the end of last month. That's an increase of 350% over five years. The price of steel has climbed from under $240 a ton for hot-rolled steel coil throughout most of 2003 to $1,125 a ton last month, quadrupling in five years.

Grains have also soared in price (BusinessWeek.com, 7/18/08). U.S. corn prices jumped from $3.01 a bushel in July 2007 to $5.37 one year later. Wheat doubled from $3.05 a bushel in July 2006 to $6.02 last month. A Midwestern bakery owned by one of our portfolio companies turns out 13 million pies a year. The cost of ingredients of a standard pie jumped 100%, from $1.20 a year ago to $2.40 today.

In every sector, cost increases are so large and pervasive that producers who might once have tried to absorb or work around them are passing them on to customers as fast as they can. Dow Chemical (NYSE:DOW - News) recently announced successive price increases of 20% and 25%, plus freight surcharges, saying energy and feedstock costs had risen fourfold in five years.

China's Role

With commodity costs rising for so long, why are we feeling the impact so suddenly?

The answer is that China can no longer bail us out with low-cost manufacturing. For years, American manufacturers and retailers offset rising costs by sourcing more products from China, where they could be made cheaply. That kept prices down for American consumers and also restrained pressures on wages, abetting price stability. But now costs are rising quickly in China, too (BusinessWeek.com, 8/12/08).

The Chinese government, under pressure from the U.S., let its currency float upward by 21% against the dollar since depegging it in July 2005. It also increased its value-added tax by 11%, and removed rebates of the tax for most exporters. New labor laws, coupled with a tightening market for skilled workers, have pushed up labor costs by about 50% over the last three years. Meanwhile, Chinese producer prices rose by 10% in July, the fastest rate of increase since 1996. As a result, Chinese producers are demanding -- and getting -- price increases of 20% to 25% on goods they make and sell to U.S. customers.

Without the Chinese life preserver, prices at the big-box American retailers are likely to be soaring in the near future, and Chinese manufactured parts and components that go into U.S. cars and appliances are likely to experience similar gains.

Admitting We Have a Problem

Most Americans will have to tighten their belts and accept lower living standards unless this inflationary spiral can be stopped. There will be pain -- higher prices and a weaker economy, resulting in fewer jobs. Meanwhile, millions of Americans who are already feeling poorer because of falling home values and a soft economy will be further pinched by higher prices for heating oil, groceries, clothing, autos and appliances. Labor is unlikely to remain so quiescent, particularly as the expectation of inflation becomes clear.

The federal government and the Federal Reserve will be under pressure to take tough and politically painful steps to curb this inflation, including strengthening the dollar, raising interest rates, and tightening credit. But the Fed's ability to raise rates is constrained -- it needs to keep rates low to manage the mortgage-backed bond mess.

The first step in solving the problem is to recognize that we have one -- and it is serious. No American housewife has any doubts about that. Our policymakers shouldn't, either.

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