Many pundits were spinning the inflationary story when factory prices continued higher in March, and they were quick to point out how rising factory prices will trickle down to consumer prices in the months to come. High factory prices must certainly mean high consumer prices, yet the data does not show a lagging increase in consumer prices when factor prices rise. History shows that high factory prices are deflationary and tend to be recessionary.
At face value, it seems obvious that rising factory prices should directly transmit into higher consumer prices in the months to follow as goods leaving the factory floor are delivered to retailers. Yet, the relationship between producer prices and consumer prices is mediocre at best.
Few understand how the global economy works and what it means to be the global reserve currency. The reason rising factory prices do not directly transmit to higher consumer prices has everything to do with the dollar being the world’s reserve currency.
As the global reserve currency, the United States needs to export dollars to the rest of the world. To export a large number of dollars, the United States must be a net importer of goods and services. For foreign producers, the most profitable time to export to the United States is during periods of high producer and consumer prices.
When producer prices rise in the United States for any reason, which could be increased regulations, taxes, higher input prices, or higher labor costs, it is an invitation for foreign producers to increase exports. Foreign producers tend to have lower production costs compared to domestic producers, so higher domestic production costs equate to higher profit margins for foreign producers.
During periods of high domestic production costs, imports surge as foreign producers race to undercut domestic producers to gain market share. This rush to export into the United States is evident by backlogs at U.S. shipping ports as cargo ships rush to unload foreign-produced goods.
For wholesalers and retailers, rising consumer prices often lead to reduced sales especially when wages are not keeping up with inflation. To maintain sales, wholesalers and retailers will eagerly purchase from the lowest cost producers to keep prices as low as possible. Consumers, who are becoming financially burdened by higher prices, will also gladly purchase less expensive foreign-produced goods and services.
As wholesalers, retailers, and consumers switch to less expensive foreign-produced goods and services, consumer price inflation begins to slow. In turn, domestic producers attempt to compete by reducing profit margins which also helps slow the rate of consumer price inflation. With domestic and foreign producers aggressively competing for sales, consumer price inflation eventually dissipates.
The reason high producer prices are deflationary is simply due to the United States being the global reserve currency. When producer and consumer prices in the U.S. are high, foreign producers are highly incentivized to export to the U.S. where they can undercut domestic producers. This relationship forces domestic producers to lower prices which leads to lower inflation.
As demand for domestically produced goods slows, this creates further problems for domestic producers who are forced to compete against less expensive foreign-produced goods. Domestic producers look to automation to reduce costs which ultimately leads to a reduction in the number of employees.
With a lag, high producer prices lead to an increase in initial unemployment claims. It makes sense, that as demand for domestically produced goods declines, the need for employees also declines. For domestic producers, employment costs are often one of the few variables they can control when it comes to the total production cost of a good.
By increasing automation and reducing headcount, domestic producers can reduce costs to compete with foreign producers. The winner of this war is ultimately the American consumer who benefits from lower-priced goods but it comes at the sacrifice of jobs.
Most Americans do not understand they are competing with low-wage foreign workers for jobs. In the manufacturing sector, the competition between domestic and foreign labor is high. The advantage often goes to foreign labor, who can frequently do the job of a domestic worker at a fraction of the price.
While many believe higher producer prices will lead to higher consumer prices, it is not true. Due to the design of the global monetary system, foreign producers are highly incentivized to compete with domestic producers when prices rise. The U.S. does nothing to protect American workers, as policymakers know the U.S. must be a net importer of goods and services to be a net exporter of dollars.
High producer prices end up being deflationary as domestic producers compete with foreign producers on price. As demand and profit margins for domestically produced goods declines, so too is the need for employees. As more employees are given pink slips and hit the unemployment line, the U.S. economy is soon to slip into a recession.