The Dollar Will Break Inflation

The headline inflation rate, or Consumer Price Index rose +5.3% over the past twelve months in August as the annualized rate of change in the index appears to be peaking. Investors and consumers are convinced inflation will continue to rise even higher much like it did in the 1970s. Few realize, the dollar is slowly gaining strength and is going to slow the rate of inflation, perhaps significantly as it did during the Great Financial Crisis.

Part of the reason investors believe inflation will head higher is due to the rapid ascent of the Producer Price Index that measures the average change over time in the selling price by domestic producers for their output. The Producer Price Index is extremely sensitive to commodity prices which feed into the input costs producers pay.

The broad belief is that higher producer prices will lead to higher consumer prices. Since January 1941, when both the producer and consumer price indices existed together, there is no direct relationship between producer and consumer prices.

While there are times both producer and consumer prices rise at the same rate, there are many instances where producer prices are rising at a faster rate than consumer prices. Often, when producer prices rise faster than consumer prices, a recession is imminent.

The easiest way to see how higher producer prices lead to a recession is by subtracting producer prices from consumer prices. In chart form, it is easy to see that when producer prices rise too quickly, and consumer prices are unable to keep the pace that a recession is soon to follow.

The explanation for the ensuing recession is rather simple, as producers are unable to pass their rising costs to consumers. Without equivalent increases in wages to absorb higher prices, consumers reject higher prices by being forced to consume less.

Over time, inventories begin to rise as goods start collecting dust on shelves. Retailers, who have bills to pay, start to discount, and put pressure on wholesalers and retailers to dip into their margins to move the stagnating inventory. As inventories back up, the entire supply chain slows as manufacturers cut production and employees. This cascading effect through the supply chain leads to even less consumption and ultimately causes the economy to slow.

Currently, producer prices are rising at the fastest pace compared to consumer prices since the Great Financial Crisis. While rising producer prices were not the catalyst for the last major crisis, it has become a foregone conclusion that consumer prices will surge higher.

Yet, there is little evidence consumers will be able to afford those higher prices. Unit Labor Costs for All Employed Persons, or how much a business pays its workers to produce one unit of output, is currently at 1.3% over the past twelve months as of the second quarter while the Consumer Price Index over the past twelve months as of August is at 5.3%.

It is clear wages are not growing fast enough to support higher prices which is necessary to substantiate higher consumer prices. Historically, when consumer prices are rising and unit labor costs are falling, higher consumer prices will be rejected and lead to a period of disinflation and potentially deflation until wages rise enough to afford those higher prices.

The biggest and most unforeseen factor that will break inflation is the U.S. Dollar. Despite consumer and producer prices continuing to rise, the dollar has been slowly gaining strength since early 2021. The value of the dollar has a direct impact on commodity prices and in turn on producer prices that are highly sensitive to changes in input prices.

There is a strong relationship between the value of the dollar and subtracting producer prices from consumer prices. It becomes clear that a rapidly rising dollar is a likely catalyst for breaking inflation, which happens commonly during recessions, as a rapidly rising dollar slows the rate of increase in producer prices compared to the rate of increase in consumer prices.

The dollar remains the most important factor to determine if inflation will persist or if it will come crashing down as it did during the Great Financial Crisis.  As the dollar continues to gain strength, the probabilities diminish that inflation will persist.

It is more likely we are on the eve of a replay of the Great Financial Crisis wherein similar fashion producer prices rapidly rose and consumer prices did not since consumers could not afford higher prices then just as they cannot now. A rising dollar broke inflation during the Great Financial Crisis and is likely to do the same again should it continue rising.