US manufacturers can’t pass inflation on fast Enough

NEW YORK – Over the past 48 hours the Federal Reserve’s tone has turned “hawkish,” St. Louis Federal Reserve Bank President James Bullard said on June 18, prompting the fifth decline in US broad equity indices in a row.

Bullard told CNBC, “We’re expecting a good year, a good reopening. But this is a bigger year than we were expecting, more inflation than we were expecting. I think it’s natural that we’ve tilted a little bit more hawkish here to contain inflationary pressures.”

The St. Louis Fed chief suggested that the Fed might raise interest rates in 2022, rather than in 2023 as the Federal Open Market Committee hinted at its meeting on Wednesday.

What’s scaring the Fed?

At some point inflation always leads to recession, when consumers can’t pay higher prices and businesses can’t maintain profit margins against rising input costs.

Consumer price inflation rose at an 8.7% annual rate in May, while wages are growing at 3% a year. Double-digit increases in housing and used-car prices haven’t begun to work their way into the official inflation data, but consumers are hurting.

Retail sales, as we noted on June 17, fell in May, by 1.3% in nominal terms and 2% in real terms.

In this Chart of the Day, we see evidence that the gap between prices paid by manufacturers and prices received from customers is depressing output. The Philadelphia Federal Reserve has conducted a monthly survey of manufacturers, who report changes in their input and output prices.

Shown below is the difference between the proportion reporting higher prices paid for inputs and the proportion reporting higher prices for finished goods. Note that the big declines in this gauge coincide with major recessions in 1979, 2000 and 2009.

We also see inverse movement during the past few years between prices paid versus received difference and the Philadelphia Fed’s measure of new orders.

The Philadelphia Fed Diffusion Index for orders is down to 22 from a peak above 40, which suggests slower but still positive activity.

The trouble is that the prices paid versus received difference leads future activity with a lag of up to 18 months. As the bar chart below indicates, past values of the paid-vs-received difference are highly correlated with present values of the Philadelphia Fed’s overall activity index—and this effect persists for about eighteen months.

None of this is news to Fed economists, who assembled this data in the first place. It might be the case that the Fed looked at the numbers for the past month and now fears that the spike in inflation they failed to anticipate will lead quickly to economic weakness.