Today the CPI for November 2010 is released. The headline CPI increases by 1.1% over November 2009. The core CPI increases by 0.8% over the same month in 2009. Both readings are well below the Federal Reserve’s long term target inflation rate of 2%, reinforcing the Fed’s worrying about deflation rather than inflation.
Worry should Fed. QE2 has not shown its intended impacts of improving employment and lifting inflation in the US. But China and a large part of emerging economies have already felt the heat. Nearly all commodities have seen their prices rising sharply in the past two months. The latest China’s CPI growth rate is 5.1%, the highest in over two years.
Fed might have this scenario in mind when the FOMC decided to implement QE2 last November. In addition to stimulate business investment in the US, QE2 causes inflation to rise in emerging economies, which implicitly reduces the cost advantage enjoyed by those regions. Then, the imbalance between the US and emerging economies could be somehow corrected. However, as the global supply chain is tightly integrated today, the US may have to bear the cost of QE2 before the benefit is felt.
The reason is simple. So far, commodity prices reacted much stronger to QE2 than CPI in the US. The pace of commodity price appreciation is so fast that the adjustment in the global supply chain has not occurred yet. US corporations have already seen their input price hiking. However, when the unemployment rate has stayed above 9% for nearly 20 months now, the consumer prices in the US have little room to increase further.
While companies cannot pass the higher costs of raw materials to final consumers, in short term, there are two likely results. The first result is that corporations will have to cut their profit margins since they cannot fully pass their increased costs to consumers. Lower profit margin means less incentive to invest and expand. Another result is to cut other costs (mainly labor cost) to offset the hiking material prices. Cutting labor cost will reduce wage, increase unemployment, and then put more pressure on consumers. Both results spell trouble for the whole economy and the stock market.
Historical data has proved the above point. The following chart presents the monthly S&P 500 Index and the growth rate of US core CPI minus the growth rate of Import Price Index from China to the US. Since China is often the last step in the supply chain: assembling and shipping goods to the US, the growth rate of Import Price Index from China could measure the production cost of US companies (a better measurement than PPI in the US).
The chart shows that S&P 500 largely lagged the growth rate of core CPI ex the growth rate of import price from China. More importantly, whenever core CPI ex import price moved across zero, the major turning point of the stock market happened in a very short period or even at the same time. Import price index from China is only available since December 2003. In the past seven years, the growth rate of core CPI ex import price from China only moved across zero twice. It first fell below zero during the period between the end of 2007 and the beginning of 2008. S&P 500 index reached its peak during that period. Then, the rate rose above zero at the beginning of 2009. One month later, S&P 500 index touched the bottom.
After the CPI release today, the growth rate of core CPI ex import price is at 0.4%, continuing its downward trend. Given the rising inflation expectation in China and the danger of deflation in the US right now, that rate is falling below zero again-companies will bear the increasing costs and see their profit falling. Is the next turning point of the stock market right in front of us now?
