Sharp declines in prices for grains and gasoline will be the most effective stimulus for renewed growth, by easing the squeeze on household finances across North America and Western Europe, but only if price cuts can be sustained.
Relative declines in prices for food, clothing and fuel have been one of the big drivers of rising living standards since the end of the Second World War, lifting millions out of poverty and freeing up a larger share of income for spending on other goods and services ranging from consumer electronics to college education and health care.
But since 2002, that source of improving welfare has ground to a halt and gone into reverse. Prices for the three basic necessities of food, fuel and clothing have risen faster than incomes in the United States and Western Europe, leading to an intense squeeze on household budgets.
By the second quarter of 2011, these three necessities accounted for 14.9 per cent of all consumer spending, up from 14 per cent 12 months earlier and the highest level since Q1-Q2 2008, and before that Q2 2000.
Unlike previous peaks in spending on food, fuel and clothing, which came at the end of booms, the current one has occurred while the U.S. and European economies are still in the early stages of recovery, illustrating the shift in price setting from the United States to households and businesses in China and other emerging markets.
Economists remain divided about precisely how commodity prices have a negative impact and how central banks should respond.
Research by California Professor James Hamilton established that there is a close association between rising oil prices and recessions. But the transmission mechanism is disputed.
Hamilton focuses on the squeeze in incomes and increased uncertainty caused by sudden price changes in items that account for a significant and very visible part of household costs.
In contrast, Fed chairman Ben Bernanke insists that mistaken policy responses (hiking interest rates in response to one-off price rises) rather than rising prices themselves have been responsible for much of the apparent link between oil shocks and recessions.
Either way, there is no question rising oil and food prices played a significant role in triggering the recent slump in growth.
Major big-box retailers such as Wal- Mart and Target in the United States and Tesco in the United Kingdom, which capture a big share of consumer spending and see how rising food and fuel prices affect spending first hand, have all reported a significant impact.
(Consumers) are trading down, consolidating shopping trips to save on gas and generally not spending a lot on discretionary purchases, according to a Target executive interviewed by theWall Street Journal( Frontier of Frugality Oct. 4).
Micro and macro
Bernanke and his supporters point to the slower rate of core inflation to support the case for looking through a temporary uptick in consumer price inflation. The Fed has also pointed to the recent peak in oil and other prices to argue that the burst of inflation is temporary. But both points are based on logical errors.
Like other central banks, the Fed analyses core and non-core components of inflation as if they were semi-independent. In reality they are inextricably linked, and not just in the way the central banks acknowledge.
The Fed s main concern is whether rises in the non-core food and energy components filter through into faster increases for prices of other items or an increase in wage demands.
So long as these so-called second round effects are absent, it sees little impact from rising food and energy costs. Increases in food and fuel are treated as microeconomic phenomena linked to supply and demand conditions in individual markets.
In reality, food, fuel and clothing account for such a large and visible share of household expenditures that price increases cannot be analysed on their own separately from core items.
If prices for food and fuel rise rapidly, constraints on household budgets mean prices for other items must rise more slowly or even fall.
The Fed could always try to offset the depressing effect of rising food and fuel prices on the cost of other items by expanding money and credit. But assuming it was successful, it would not affect the relative rates of increase.
Broad-based increases in food and fuel prices must be analysed as macroeconomic phenomena with system-wide effects, not just microeconomic shifts in relative prices.
Limits to growth
If rising commodity prices are treated as macro phenomena, the Fed s error in assuming that price rises are transient and that prices will soon peak becomes evident.
Prices for oil and a range of other commodities have fallen more than 20 per cent since peaking in April. So superficially the Fed s forecast is correct. However, the drop is mostly due to the sudden and unexpected slowdown in the U.S. and global economy.
The Fed cannot claim that recent falls in prices vindicate its forecasts, because the drop occurred precisely because the Fed s forecasts and policies failed. If they had worked as they were supposed to, inflation would probably be higher.
Upward pressure on oil and other prices shows there is little or no output gap in these crucial sectors at the global level. The oil market has become the main speed limit on global growth. The more the Fed tries to push against it, the more rising oil and other prices counteract any stimulus.
In this context, the pull-back in oil and food prices will play a crucial role as automatic stabilizers, helping cushion the recent slowdown, provided that price falls are sustained and prices do not roar back to previous highs quickly.
John Kemp is a Reuters market analyst.
end of the american dream
Source: Bureau of Economic Analysis, NIPA Table 2.3.5
END OF THE AMERICAN DREAM SPENDING ON BASIC ITEMS AS PERCENTAGE OF ALL PERSONAL CONSUMPTION EXPENDITURES
Gasoline and Energy
1963 1968 1973 1978 1983 1988
Food and Beverages (off premises consumption)
1993 1998 2003
Clothing and Footwear