Wholesale Prices Plummet in February

The Bureau of Labor Statistics reported on Tuesday that the producer price index (PPI) for February fell by a dramatic 1.4 percent, indicating an annualized rate of deflation of 15.6 percent at the wholesale level. This surprising result was driven by falling costs of food, which experienced a decline of 2.7 percent for the month, and energy, which slid by 4.7 percent. The so-called "core" producer price index, which excludes wholesale prices of food and energy, rose by three-tenths of a percent, representing an annualized inflation rate for wholesale goods other than food and energy of approximately 3.7 percent.


Although the dramatic drop in wholesale prices was something of a surprise to economists, the jump of 0.3 percent in the core PPI was quite a bit larger than expected: the consensus among economists was that wholesale prices other than for food and energy had risen in February by a modest 0.1 percent, meaning that the actual figure was triple what had been anticipated by experts. This surprise comes on the heels of the revised core PPI of 0.4 percent for January. The graphic at left shows the core inflation rate over the past six months for which data is available. As noted, the core does not reflect the whipsaw of energy prices that have plagued the economy during the past several years. Although many anticipated that, as the military and political situation in Iraq stabilized and that country was again able to deliver significant amounts of oil to the world markets, energy prices would generally decline and no longer exhibit the up and down swings that characterized the first months after the invasion by Coalition forces led by the United States. Because of the continuing insurgency in Iraq—an insurgency some now characterize as civil war—and because of the attendant, continuing supply disruptions, the global markets have continued to be roiled. Although an important part of the continuing volatility of energy prices at both the wholesale and retail level, the situation in Iraq is but one of many factors contributed to edgy, volatile world markets for hydrocarbon products. Among the other causes of oil price volatility have been a spate of temporary refinery closings in the United States due to fires and natural disasters, as well as concerns on the international stage about the possibility of widened conflict in the Middle East and threats by Iran to curtail sales of oil to the West in the face of threats by the United States and the several European nations regarding the Persian nation's on-going nuclear research and development program.

No doubt exists that there has been a general trend upward in wholesale and retail energy prices since at least the beginning of the Bush Administration, but it could be argued that the substantial February decline at the wholesale level indicates the possibility that the worst of the overall price increases might be coming to an end, at least for a while. The Bureau of Labor Statistics reports that the 4.7 percent slip in energy prices was largely the result of a 9.5 percent slide in gasoline prices paid by retailers and a stunning collapse of 24 percent in wholesale natural gas prices. While these declines represent real respites at the wholesale level, there is no reason to believe that a significant portion of those savings were passed on to consumers and businesses that pay retail prices. More importantly, however, is that the volatility in and of itself of energy prices has an adverse effect on wholesalers, just like similar volatility in retail prices adversely affects those who pay the prices at the level of final goods and services.

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As a general rule, companies do not want to experience gains and losses merely because of rapid, unpredictable swings in the costs of inputs. To make net cash flows more predictable, large companies form positions in securities so they will gain on the investments if they lose money on the factor cost, and they will lose on the investments if they gain on the factor cost. This is called "hedging."

  The problem is that, when prices swing wildly from month to month and even from week to week, consumers and businesses become more defensive in their spending patterns because of the increased uncertainty with which they must make spending plans. For example, even if, on average, the overall cost of energy rose by a relatively modest two percent over a year, the business could face considerable budget challenges if in two consecutive months the cost of energy first fell by fifteen percent then rose by seventeen percent. The volatility has created business planning risk, and this same principle of increased risk is faced by households. For both households and businesses, this elevated level of risk tends to encourage a less aggressive planning pattern for expenditures. An interesting differential effect can also be noteworthy: large and medium-sized firms can use the financial managers and brokerage services to hedge against a substantial share of random price volatility. This is one of the important benefits of so-called derivatives, which are used to buffer the ups and downs of everything from energy costs to exchange rates. The securities in a hedging portfolio earn money as a certain price moves adversely to a firm's business position and lose money as that price moves favorably to the firm's business position; hence, the derivate acts to nullify or at least to mitigate the non-business related volatility in the firm's earnings. Unfortunately, however, small businesses and consumers are rarely able to deal in these types of investments, both because of the up-front costs of getting involved, as well as because of the significant amounts of capital required to regularly and continuously participate in hedge markets, where exacting care and high costs deter occasional, untrained, and amateur investors.

With respect to the inflation in the United States economy, even as the federal government's inflation figures continue to present a picture of price levels that is not in any way pointing to catastophe, the underlying situation may be quite different because of controversial data manipulation techniques used by the Bureau of Labor Statistics. Two of the principal techniques are "hedonic pricing" adjustments—downward corrections of price increases on the assumption that some part of any given price rise is not inflation, but merely a reflection of quality improvement—and "substitution effect" corrections—lowering actual, observed price increases under the assumption that, as the prices of certain goods rise, people will substitute away from those goods, thereby mitigating the effects of the price increases.

Regardless of how the federal government's figures deviate from the experiences of businesses and households in the actual economy, management of the underlying inflation rate is the responsibility of the Federal Reserve, which is supposed to be independent of the government and the particular political party that might be dominating fiscal policy. Although the Federal Reserve many months ago, while under the chairmanship of Alan Greenspan, stated clearly that monetary policy to the purpose of accommodating the Bush Administration's fiscal policies was coming to an end, the continuing inflation at both the wholesale and retail levels appears not to be responding adequately, at least not so far. Moreover, as the government continues to report that inflation is far tamer than what business and households are experiencing, the current chairman of the Federal Reserve, Ben Bernanke, and his fellow Fed Governors will have considerable leeway to allow the Federal Reserve to continue printing money at a rate in excess of what is necessary for the real growth rate of the economy.

The Federal Reserve's motivation for printing excessive amounts of money is transparent: it is that excess money that allows the Fed to "monetize" the irresponsible budget deficits being run by the radical Republicans in Congress and in the Administration. Essentially, the Fed is printing the money it needs to participate—either directly or through the financial intermediaries of its banking system—in Treasury auctions to purchase debt instruments the government is issuing to pay for its expenditures that exceed its tax revenues. And the reason the government cannot pay its bills is because of its profligate spending on a war of opportunity, coupled with the severe erosion of the taxable revenues it collects from the wealthier people in the nation who were the primary beneficiaries of three rounds of tax cuts instituted by the Bush Administration and its Republican allies in Congress.

The enduring comfort to be found in this otherwise dire current state of affairs is that it cannot last indefinitely. That, on the other hand, is also what should worry everyone enough to lose sleep at night: ultimately, the gambit will come to an end; and when it does, few will be the places that average Americans may turn for help, and even fewer will be the places the neo-conservatives may hide from retribution.


The Dark Wraith will in all circumstances be available, if for nothing else, to note that everyone was sufficiently warned.