Labor's Fall -- Not Oil's Rise -- Is Key to Inflation

Wisconsin labor protest
Wisconsin labor protest

Popular revolts and populist stirrings in the Middle East and the American Midwest have fixated Wall Street lately.

At first glance, the connection between rebels in Libya and public sector union demonstrators in Wisconsin is hardly obvious. But both are vital to markets right now, since how those movements fare will determine the direction of key macroeconomic trends that could propel or derail the blooming economic recovery.

Both are also keys -- in rather unexpected ways, perhaps -- to the inflationary fears that have been growing lately -- not just on Wall Street but on Main Street. For all the attention focusing on the inflationary role of rising oil prices, it may be the disintegrating power of organized labor on full display in Wisconsin that keeps inflation in check.

Stagflation Fears

For plenty of pundits, the imminent arrival of major inflation is a foregone conclusion, thanks to the Fed's nearly unprecedented easing of the money supply following the financial crisis. These economy-watchers point to the rising prices of a range of commodities, from metals to cotton to foodstuffs, as evidence that their predictions are playing out.

Surging oil prices are only adding to that panic. The pessimistic view is that crippling, 1970s-style stagflation is in the cards as spiking energy costs put the brakes on economic growth and reduce consumer purchasing power in one blow.

But rather than succumbing to the alarmism of any of these hyperinflationary scenarios, investors are better off taking a more measured approach. A recent research note by Citigroup (C) stock strategist Tobias Levkovich points to why.

What Causes Real Inflation? Wage Growth

Despite all the worry over the impact of rising oil prices, recall that the U.S. is now a largely services-based economy, and observe that the rising wages that have led to real overall cost rises in decades past are nowhere to be found today. In the inflation pessimists' superficial comparisons of the current environment to the 1970s, the dwindling impact of labor unions is often overlooked.

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"[I]nvestors often forget that cost of living adjustments built into labor contracts during the late 1960s and early 1970s, when the private sector had 25%-30% unionization rates, forced upward pressure on companies across the business spectrum and causing a massive change in inflation expectations," Levkovich wrote. "Such conditions do not exist currently due to productivity enhancement via technological advances, outsourcing and offshoring."

Levkovich makes a compelling argument when he dismisses the widespread concerns about oil prices. He points out that oil rose from $9 a barrel in 1998 to $147 in 2008, a steep climb that nonetheless hardly resulted in a surge in the consumer price index. The low rate of private sector unionization -- from 6% to 7% -- may have helped prevent prices from spiraling upward.

Investors Aren't Worried About Inflation

Of course, the more conspiratorial of the inflation alarmists have another explanation: CPI figures are manipulated to understate inflation, they argue.

On that topic, Levkovich echoes a point recently made in a research note by Jim O'Neill, the high-profile head of Goldman Sachs Asset Management (GS): If the figures are simply being manipulated, why do inflationary pressures fail to show up in both investor and consumer perceptions?

"Intriguingly, the 10-year TIPs [Treasury Inflation-Protected Securities] breakdown level does not suggest that the bond market is overwhelmingly anxious about any spike in core CPI trends, plus the University of Michigan long-term inflation survey data is also not suggesting an imminent change in inflation expectations," Levkovich writes.

These points should help clarify the debate currently intensifying about whether the Fed should start to tighten the money supply and raise interest rates just as the economy is picking up some momentum.

Despite plenty of howling from a certain variety of pundits, any evidence of runaway inflation is scant. And investors need look no further than the other half of the Fed's mandate -- promoting employment -- to see why.

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