Prices rise in a deflationary environment, a recipe for more business bankruptcies. 

U.S. Consumer Prices Unchanged; Core Prices Increase.

By Bob Willis

May 15 (Bloomberg) — The cost of living in the U.S. was unchanged in April as decreases in food and energy costs offset increases in medical care, autos and a second straight jump in tobacco prices. 

The consumer price index was flat after decreasing 0.1 percent in March, the Labor Department said today in Washington. Excluding food and fuel, costs climbed a greater-than-forecast 0.3 percent, almost half of which reflected an increase in excise taxes on cigarettes, according to Labor. 

Companies from Gap Inc. to Toyota Motor Corp. are keeping a lid on prices to draw buyers amid the deepest recession in five decades. Still, recent increases in commodity costs and Federal Reserve efforts to thaw credit markets by pumping cash into the economy will help lower the odds that broad-based price declines, or deflation, will take root, analysts said. 

“Demand simply remains too weak for most businesses to find any success in pushing through price hikes at this point, Russell Price, a senior economist at Ameriprise Advisor Services in Detroit, said before the report. “Widespread price cuts however, are also unlikely especially given the recent evidence that the economy may be stabilizing.”

In any event, prices are too high and as wages continue to decline the affordability of goods also declines. If businesses cannot sell goods and services the result is the failure of the businesses. This failure adds to the numbers of unemployed which pushes the level of wages even lower reinforcing the downward spiral.

Since the end of last year, crude oil prices have increased from $35 to $58 a barrel against a backdrop of diminishing demand.

According to the Energy Information Agency total world demand for liquid fuels has dropped approximately 4 million barrels per day since the first quarter of 2008. While this is substantial, OPEC disciple in maintaining a cut in production and (somewhat slow)  growth in cosnsumption in China and other developing countries is tending to firm prices. 

Consumption worldwide in 1Q 2008 was 86.50 mpd versus 82.68 mpd for this year’s first quarter. While it is generally difficult to predict where prices will go, the current distorted market is adding higher costs to all products made with and transported using petroleum. This is destabilizing as the higher relative prices result in generally less consumption of goods and a downstream failure of the businesses that rely on income from sales.

Business failure is a hard way to enforce energy conservation and also manage prices. The mechanism works against itself as business decline and failure eventually brings prices down. At the same time, there is less investment in energy infrastructure. The low prices also tend to encourage greater consumption. The tandem of high relative consumption against investment- constrained supply results in more price instability, even price spikes or shortages.  The result is even more business failure and the cycle is amplified.

The increase in overall price level and energy prices in particular can be divided between the still relatively strong demand for energy and leakage of Fed liquidity out of fnance and into the general economy. A problem is the Federal Reserve appears to confuse inflation with recovery. This latter cannot be caused by simmply lending to the finance sector. This does not add to the circulating money supply – there is no velocity. Inflation simply cannot take root, any increase in circulating money will fly into liquid assets such as stocks and commodities. Energy prices will react by increasing, which is exactly what is happening. Eventually, there is a return to deflationary conditions; the price increases take place ahead of any wage increase or increase in aggregated worker earning power. There are millions of unemployed and underemployed who do not have any money.  

It appears that some of the liquidity leakage is already takng place with rallies in both commodities and equities that are liquid to some degree and accessible to the financial wizards who have some skill at blowing price bubbles. In 2006, such a bubble might gather some public participation, now it is simply self- defeating.

Here’s a market call; despite the lack of market depth … with all that Fed liqudity sloshing around with few places to go, the stock market rally – particularly energy stocks – still has some legs. Oil prices might move up to $70 or more before the higher levels signal a return to deflation.