Food and Gas Prices are on the Rise

The labor department released price indexes that show that how tame inflation has been in every area except two essential things:  food and oil.  Most consumers do not follow the Wholesale Price Index.  This is because it takes awhile for price increases in wholesale items to translate into inflation at the retail level.  It doesn’t  translate into a one to one increase either so it’s not a precise indicator of future inflation.  Economists are interested in the wholesale index because its usually a precursor to future general price movement.  The index was up 1.6 percent with most of the increase attributable to food or energy.  These are price increases considered outside ‘core’ inflation.  I wanted to explain some differences in inflation measures to you so you know how to understand this information.

Economists generally track the GDP deflator and the core PCE.  The GDP deflator is the broadest of all the price indexes that measure inflation (price increases) or deflation (price decreases).  It’s a weighted index that relies on the buying habits of current year/quarter/month GDP to weight the various contributions of price changes of goods and services.  Thing bought more frequently or with larger prices have a larger weight in the index.  The Consumer Price Index or CPI relies on a fixed basket or typical budget to weight the contributions of price changes to the selected group of consumer items in that index.  The Personal Consumption Expenditure index or PCE is similar to the CPI in that it measures just retail prices like the CPI but it uses the average prices increases using weights on each price from the current and preceding periods.  It does not rely on the fixed basket which can be seen as a typical household budget.   This index removes some of the problems inherent with using the CPI that relies on its fixed basket.   The most notable problem is the substitution impact which means people move their budgets around when prices change.  They substitute one item for another.  This switch isn’t captured when the index relies on a fixed basket that doesn’t change very often.

The importance of the ‘core’ inflation measures cannot be understated here. Core indexes don’t include the most volatile items. Food and energy prices are typically removed from core indexes because they are subject to ‘shocks’ from bad weather and supply disruptions.  We’re seeing a large number of disruptions right now from both weather and the political unrest in oil producing countries.  Future inflation at the retail level will show up first in wholesale prices so the Wholesale Price index is seen as a predictor of future, overall, inflation.  What we’re seeing now is the impact of price instability from food and energy which are not part of  core inflation  but are highly essential to both businesses and households.  Energy is obviously important to developed economies.  Food is an essential expenditure in developing nations both as an important and export.

The Labor Department said Wednesday that the Producer Price Index rose a seasonally adjusted 1.6 percent in February — double the 0.8 percent rise in the previous month. Outside of food and energy costs, the core index ticked up 0.2 percent, less than January’s 0.5 percent rise.

Food prices soared 3.9 percent last month, the biggest gain since November 1974. Most of that increase was due to a sharp rise in vegetable costs, which increased nearly 50 percent. That was the most in almost a year. Meat and dairy products also rose.

Energy prices rose 3.3 percent last month, led by a 3.7 percent increase in gasoline costs.

Separately, the Commerce Department said home construction plunged to a seasonally adjusted 479,000 homes last month, down 22.5 percent from the previous month. It was lowest level since April 2009, and the second-lowest on records dating back more than a half-century.

The building pace is far below the 1.2 million units a year that economists consider healthy.

There was little sign of inflationary pressures outside of food and energy. Core prices have increased 1.8 percent in the past 12 months.

So, what does this mean besides higher grocery bills and fill ups at the gas station?  Well, first it means that households will have to rearrange their budgets so more money will go to these things than other things.  But, there’s other news that could offset some of this.  Oil prices are actually falling on the news of Japan’s nuclear problems.

Gas prices spiked in February and are even higher now. The national average price was $3.56 a gallon Tuesday, up 43 cents, or 13.7 percent, from a month earlier, according to the AAA’s Daily Fuel Gauge. Rising demand for oil in fast-growing emerging economies such as China and India has pushed up prices in recent months. Turmoil in Libya, Egypt and other Middle Eastern countries has also sent prices higher.

But economists expect the earthquake in Japan to lower oil prices for the next month or two, which should temper increases in wholesale prices in coming months. Japan is a big oil consumer, and its economy will suffer in the aftermath of the quake. But as the country begins to rebuild later this year, the cost of oil and other raw materials, such as steel and cement, could rise.

Oil prices fell sharply Tuesday as fears about Japan’s nuclear crisis intensified. Oil dropped $4.01, or 4 percent, to settle at $97.18 per barrel on the New York Mercantile Exchange.

There are several other things in this report. First, most of the food price increases appear to be due to really bad weather in several countries.  The other more worrying contributor was the increased demand by ethanol producers for crops.  This is due to increased subsidies.  It seems really weird that we’re willing to cause hunger just for some energy production but that appears to be a building, long term issue.  Second, the cost of clothing appears to be on the increase.  This may be due to the increased costs of transportation coming with the oil or it might be an indication of future inflation.  Prices rose 1 percent for clothing.  That was the most in 21 years. Costs also increased for cars, jewelry, and consumer plastics.  Many of these items also use petroleum products as well as require transportation.  That’s a possible explanation for the price change so that would be more temporary than permanent.   So, while its cheaper to buy electronics and such, it’s much more expensive to eat and drive around for the time being.  Too bad we can’t eat our MP3 players.

I’m sure the FED is watching this since many gold bugs will see this as proof that the QE2 is ratcheting up the money supply and creating inflation.  The problem with this explanation is that the majority of these price increases can be attributable to fundamentals in markets that are typically volatile anyway.  At this point, I still wouldn’t worry about inflation if I were in charge of policy.  I’m still focused on the horrible unemployment rate and the recessionary pressures that decreased state and federal spending will bring.  My best guess is that as folks adjust their budgets for food and gas price increases that we’ll see some pretty good sales on other things.  You’ll feel these price increases more  if you’re poorer and your budget is mostly food and gas expenditures.  Otherwise, you’ll see offsets in other expenditures so it will just shift your expenditures around.