Many investors have grappled with this paradox lately: Commodity prices are blowing up, yet the Consumer Price Index, or CPI, says inflation is tame. As Fed Chairman Ben Bernanke noted last week, "we have recently seen significant increases in some highly visible prices," yet, "overall inflation remains quite low."
The standard response to this inconsistency goes like this: The CPI is a conspiracy, the Fed is lying, or Bernanke can't add.
I'll say this: The CPI is imperfect. It's flawed. It's inadequate. And it's easily manipulated. But a combination of surging commodity costs and relatively tame consumer prices isn't as bogus as some assume.
The contradiction was explained nicely in a recent Wall Street Journal article reporting disappointing earnings from food giant Sysco (NYSE: SYY): "Prices of products, including milk and meat, rose more than 10% from a year ago, and Sysco didn't pass along the full increases to customers."
The Consumer Price Index measures consumer prices, the final price of goods we buy at the store. The prices of these items don't always match the costs borne by their manufacturers. For example, if steel prices rise, the prices of steel-heavy consumer items like cars don't necessarily have to follow suit. Car manufacturers can pay for the added steel cost out of profits, rather than raising the sticker price of vehicles. Since consumers buy cars, not steel, commodity prices can rise while the CPI yawns.
And there's good reason to believe that this is happening now. Besides the Sysco example above, consider these comments from recent earnings calls:
Procter & Gamble (NYSE: PG): "Gross margin decreased 190 basis points due to higher commodity costs."
Kraft (NYSE: KFT): "There was some pressure on gross margins because price realization trailed the increase in input costs."
Whirlpool (NYSE: WHR): "The most significant unfavorable impacts on our gross margin were lower product price mix and higher material cost."
Ford (NYSE: F): "The decrease in automotive sector results is more than explained by higher structural and commodity costs."
All of these are examples of manufacturing costs rising faster than consumer prices. Rising costs. Low consumer inflation -- it can actually add up.
Here's more evidence. Besides the CPI, there's another index called the PPI, or Producer Price Index. As the name implies, PPI measures the price of producer goods -- input commodities like steel, grain, and lumber. Not surprisingly, PPI is surging, up 4% in December from the year before. Much (though not all) of the difference between PPI's 4% jump and CPI's 1.5% crawl over the same period can be explained by producers' failure to pass rising commodity costs on to consumers.
Why would a company not pass along rising costs? First, perhaps it can't. Very few companies can raise prices without hurting their sales, as consumers balk. Second, companies could be hedged, meaning rising commodity costs get absorbed by Wall Street derivatives traders, allowing companies to keep profits humming and consumer prices stable. This is what Southwest Airlines (NYSE: LUV) did a few years back. As oil prices erupted in 2008 to $140 a barrel, the airline had more than 70% of its fuel costs hedged at $51 a barrel. Accordingly, it didn't have to raise ticket prices, even as fuel prices soared. Once again: Rising input prices don't always lead to rising consumer prices.
How long can this last? There's only so much cost-absorbing companies can take before they're forced to raise prices. Some companies like Starbucks (Nasdaq: SBUX) are already raising consumer prices, if only marginally. Others have announced intentions to do so shortly. Expect more of that. And when it happens, expect it show up in the CPI. It's an imperfect measure, but it isn't lying to you.
Fool contributor Morgan Housel owns shares of Procter & Gamble. Sysco is a Motley Fool Inside Value pick. Ford Motor, Southwest Airlines, and Starbucks are Motley Fool Stock Advisor recommendations. Procter & Gamble and Sysco are Motley Fool Income Investor picks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
