Friday, May 23, 2008


The only business that posts its prices on tall signs on millions of street corners is the oil business. During times like these, when gasoline prices have moved up sharply, everyone knows and is reminded daily. As a result, people who decide to cut back on consumption are likely to follow through. Less gasoline is being purchased and thus the total amount of "extra" money being spent on gasoline is not as much as the price would indicated. Painful, but few Americans are going hungry.

Since food and fuel are prices are in our faces and very volatile, the average person today thinks that the US inflation rate is being misrepresented by the government. Support for this point of view comes from very savvy investors such as Bill Gross, but one must always remember to be cautions about accepting as truth the words of anyone who might be talking up their multi billion dollar "book". The fact that the big investment brokers have turned negative on airline stocks (after they have been pounded to ultra low prices) should not be taken as a sell indicator but as a buy indicator. Investment bankers make their money by buying assets cheap, not by selling or giving away advice.

The inflation reality is like going swimming with a bunch of teenage kids. The water level of the pool has gone up some because these kids are in the water but the big difference is in the amount of splashing that is going on. When these kids do cannon balls, they make their presence known, but they actually add less total net volume to the water level than does the same sized kid who does not splash water out of the pool. Indeed, if there is too much splashing, some swimmers may leave. The higher the price of gasoline the higher the number of people who decide to stay home or who find transportation alternatives. Conservation is happening.

The overall inflation level has not increased very much, primarily because the unit labor cost of producing products has not increased very much. Talking heads like to go on and on about how transportation costs are getting passed through to the cost of every product but they never mention how insignificant transportation costs are relative to total costs. A cost breakdown of a $100 product is in the neighborhood of $70 labor, $29 in materials and less than $1 in transportation costs. The amount of fuel expended to move a super tanker half way around the world is a very minor relative to the value of the goods transported.

If the transportation cost of the above $100 product increases by 50%, the price of the product goes up one half of 1%. If the unit labor cost were to fall 1% simultaneous with a 50% increase in transportation costs, the total cost of the product would go down 20 cents!

Unit labor cost go down for several reasons. The production process might be slightly more automated at any point along the manufacturing process or a production engineer, line worker, or distribution manager may see a way to speed the production process or the production might be moved to a lower labor cost location. The availability of low cost labor has made it profitable for knitted socks to be shipped halfway around the world and back just to have the heels sewed. Again, the transportation cost per unit is a very tiny fraction of the labor costs.

What has happened lately has been a lot of splashing around in the pool but the water level has not been rising much. Not long ago, a huge cannon ball hit one end of the pool. It caused a huge wave and several after shock waves. Oil and food rode the crest of two of these waves. The swells of these two waves were home prices and mortgage securities. It is pretty amazing for a guy on TV to rant about terrible inflation at the gasoline pump and the grocery store without mentioning that his California house has declined $200,000 in value! Has this guy experienced inflation or deflation?