In 2010, the year’s inflation rate was 1.64 percent. The year prior we experienced deflation for the first time in many decades, at -.34 percent. This year’s annual rate, so far, is averaging 2.14 percent. It’s not screaming upward, but it’s definitely rising.
For more than a decade prior to the Great Fall in the Fall of 2008, inflation ranged between 3 and 4 percent. Remember, these were expansion years with lots of capital available from lenders and investors. And we were firmly ensconced in federal deficit-spending. Now there is fear of inflation rising dramatically, because we have “printed” lots of dollars to fuel Recovery Act spending.
In today’s news, a reporter said that the Consumer Price Index’s monthly value hit an annualized rate of about 3.6 percent, even though oil prices have spiked much higher. Apparently, the increase in cost of oil-based products has not been passed on to the consumer, so inflation is not yet broadly affecting our economy, although higher gas prices alone are certainly painful.
Those concerned about inflation are also worried about the weakness of the dollar and the reduced attractiveness of our debt, with its low yields. They say that by deficit-spending, using arbitrary issuance of dollars, we also threaten the buying power of the dollar. In today’s news, however, are several stories about the strengthening dollar, due to shaky sovereign debt in Europe and no real alternative, yet, for displacing the dollar as the world’s reserve currency and the denomination for international contracts.
These are indeed worrisome factors, and should be part of our overall plan to firm up the national balance sheet over time. But I’m not so worried about inflation or being able to sell our debt, or the erosion of the dollar’s purchasing power. There are two reasons.
In most businesses, the largest single expense is labor. Usually, labor comprises half of all operating expenses, plus or minus. Some industries are higher, like public accounting or legal services. Some are lower, like marketing and distribution companies who purchase what they sell. So the largest single internal driver of pricing is labor. Until demand begins to overtake supply, salaries will not rise significantly. Some companies had to cut pay and lay off staff during the recession. They have not replaced the staff nor fully restored the prior pay levels. Nor should they, until the demand for products and services can reliably support the increased expense rate.
You might argue that U.S. labor costs don’t have the same correlation to inflation as they used to, because we buy a lot from overseas. How much of an impact are those imports? Our monthly trade deficit typically ranges between $40-50 billion. But our total monthly Gross Domestic Product, or GDP, is averaging about $1.2 trillion, and we export typically 10-13 percent of that value. We import about 14-17 percent of our GDP, ergo the trade deficit. The large majority of our GDP is sold and consumed within the United States, i.e., 87-90 percent. So the proportion of the Consumer Price Index that is driven by labor costs within the U.S. is still the major factor causing that metric to move in one direction or another. And as long as wages aren’t increasing much, anyone wanting to sell to the U.S. market cannot increase prices, else risk losing market share to someone who is holding or reducing prices.
With an import appetite of close to $2.4 trillion annually, the U.S. represents a huge market for the rest of the world’s businesses. China exports almost 40 percent of its roughly $10 trillion annual GDP. In 2010, about 10 percent of China’s exports were sold to the U.S.
India has a GDP that is less than half of China’s, at about $4 trillion, and they import more than they export, by about $60-80 billion annually, which is 2 percent or less of GDP. India sells about $25-35 billion to the U.S. each year, or roughly 1-1.5 percent of our total importing appetite.
China and India, containing about a third of the world’s population, cannot do without the U.S. as a trading partner, and still continue the improvement of economic opportunity and prosperity within their borders. Their prices will have to match what the U.S. can afford to pay, which is stable or declining, compared to the period before the Great Recession.
If China’s balance of trade equalizes, while still rising in absolute value, and exports reach a lower level of about 20 percent of their GDP, then the U.S. will be less important to the health of the Chinese economy. China will have created a strong internal market, just like the U.S. did after World War II. At that point, they might actually enact the currency reforms that would allow the renminbi to possibly replace the dollar as the world’s reserve currency and denomination of international contracts. Then, even with high unemployment, U.S. consumers would experience inflation in foreign imports.
Without lowering U.S. unemployment to around 7 percent, and/or a significant reduction in importance of the U.S. market to the Chinese and other developing economies, inflation won’t be a large threat to us. If we gradually control our deficit spending over the next decade or so, while concurrently slowly reducing unemployment by cautious business growth that focuses on a strong balance sheet, we’ll settle into a sustainably positive position in the world’s economic engine.