U.S. inflation to send wages, Fed rate higher

Interest rates south of the border will rise dramatically in 2009, as the Federal Reserve is confronted later this year by a top-line inflation rate of 6%, according a new report out of CIBC World Markets.

The culprit in this scenario is, not surprisingly, bubbling crude — oil, that is. While the high cost of energy has started to trickle down into the price of all-things-shipped, the full-force of higher transportation costs is yet to be realized.

But higher shipping costs could actually result in some improvement in the U.S. economy, boosting employment in the manufacturing sector.

“Soaring energy costs are rapidly turning global cost curves on their head,” says to Jeff Rubin, chief economist at CIBC World Markets. “As shipping costs soar with triple digit oil prices, the once omnipotent threat of Chinese competition is growing fainter every day.”

Of course, the other side of the equation is that workers will see their purchasing power eroded by the highest rate of sustained inflation since 1982. As a result, Rubin predicts the return of the cost of living allowance in collective labour agreements.

“Back in the 1980s, most collective bargaining agreements of the day had cost of living allowances built into the wage scale,” says Rubin. “Those COLA clauses largely became self-fulfilling prophesies by ensuring that largely oil price driven inflation would become self-sustaining through a wage-price spiral.”

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Such agreements could replace oil prices as the primary driver of inflation, as companies raise the price of their products to recover the increased cost of production. The wage increases generated by cost of living adjustments would stabilize inflation at a higher rate, which would force the Federal Reserve to act.

“We expect that the Federal Reserve Board will raise interest rates no less than 200 basis points by the end of next year,” says Rubin. “History says we will be very lucky if they don’t have to do more.”

When the inflation rate briefly hit 6% in 1990, the Federal funds rate was three times higher than it is today, at about 7.5%, and the 10-year Treasury was yielding 8.5%. Today, the 10-year bond yields just 4.09%.

Recent declines in the price of oil are simply a short-term correction, Rubin contends, and do not indicate a reversal of the trend toward higher prices. Production in the Middle East has been in decline, while at the same time domestic demand for oil in producer states has increased. The result so far has been a drop in exports totalling 700,000 barrels per day. Rubin predicts an additional fall-off of one million barrels per day over the next four years.

Domestic demand for oil will be driven by the rapidly developing economies in the Persian Gulf, with almost all electricity coming from oil and gas fired generators. Not only are the economies of these countries growing, but so are their populations, which will require an additional 50 billion cubic feet of water annually.

Desalination plants are the best bet for providing that fresh water, but the CIBC World Markets report points out that these plants require huge amounts of energy, draining another one million barrels of oil per day from the export market.

Many developing economies, especially those rich with oil and gas, subsidize the domestic energy prices as a means of stimulating growth.

A new report out of the Conference Board of Canada points out that developing economies are propping up the global economy, as the U.S., Japan and Europe continue to slow.

“Developing countries, especially those in Latin America and the Asia-Pacific region, have sustained their strong growth rates in part through trade diversification away from dependence on the struggling U.S economy,” said Kip Beckman, principal research associate.

In the Conference Board’s World Outlook – Summer 2008, global growth is expected to be 2.8% for 2008, with the Asia-Pacific region posting real gross domestic product growth of 4.7%. Latin America is expected to benefit from diversifying trade beyond the United States, and the regional economy should post a growth rate of 4.4%.

Beckman echoes Rubin’s outlook on inflation, pointing out that the problem is not confined to the U.S. Rising food and fuel costs have become a “fact of life in both developing and developed countries.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/30/08)