The Hindu Business Line : A recipe for inflation

Crude oil once again hit a 13-year high and has also dented the hopes of any quick easing-off. The low inventories of US and surging economies like China along with the OPEC's refusal to increase production make the outlook murkier.

Commodity prices, like that of steel, have also been moving up; some of them are being driven up due to supply constraints. China is now a very large importer of steel. Some projections of prices of commodities last year had presumed a significant Chinese slowdown and consequent tapering off of demand; however the opposite seems to be happening. One would wonder if the rise in commodity prices can feed into core inflation. In case the core PPI (producer price index) moves up, it would affect the Federal Reserve policy.

If we look at the PPI (excluding food and energy) to get a hang on the underlying trend on inflation, one would have to look at the factors that affect the core PPI.

To examine the PPI, one would have to look at the inflation at three stages, inflation in the prices of inputs, intermediate inflation and finished goods inflation. The first one is obvious and one can simply look at the input price trends.

The demand would also be a function of capacity utilisation. Hence this number is critical for looking at the inflation. The US capacity utilisation data indicates that this was around 73.6 per cent in fourth quarter of 2003. The long-term average of capacity utilisation has been close to 79.4 per cent and this is where it should be by the end of this year.

Empirical models seems that if the capacity utilisation moves up by four percentage points, the commodity prices would grow by around 10 percentage points. However, will the global competition this year allow the US capacity utilisation to move up this much?

The underlying weak dollar trend is likely to continue this year and we expect the dollar to move down by around 10 per cent on trade weighted terms. This is likely to increase prices by around 10 percentage points. Also any rise in unit labour cost would also raise the material prices.

The supply side on commodities would improve as the terms of trade with Australia and New Zealand are improving. The pressure on prices could ease off if Chinese attempts at cooling off its investment boom start showing impact.

The crude material inflation affects the intermediate prices. Empirical study suggests that 10 per cent increase in crude material prices in 2004 would add around one percentage point in intermediate prices. The average hourly earnings and wages put pressure on intermediate core PPI. A one per cent rise in average hourly earning may increase intermediate core PPI by half a per cent.

However, the US job data indicates that there is weakness in wage along with no significant increase in jobs. This is likely to keep the intermediate inflation low.

The finished goods core inflation would be once again be driven by the capacity utilisation, trade weighted dollar and manufacturing Employment Cost Index (ECI). There is a cyclically depressed utilisation rate which is unlikely to surprise, given the global competition and weak wage growth would keep the ability of the price increases at the earlier stages to pass through to the finished goods.

Hence the chances of any finished goods' core PPI moving up looks bleak. This may also have impact on the corporate profitability. Even though intermediate good inflation may move up by 2-4 per cent, this cannot pass through in to finished goods.

This would help the Federal Reserve in keeping the interest rates on hold well into the next year.

The surge in commodity prices should not give inflation watchers any anxiety till the US employment sector start showing strength which looks like a distant dream right now.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)