Inflation Update: The Labor Cost Shoe Has Dropped

The Update:

On Friday (January 28th), a series of economic statistics were released including two inflationary measures, the Employment Cost Index and the PCE Core Deflator. Both reinforced the inflationary pressures that I have been writing about for months and underscored the hawkish pivot by Federal Reserve Governors including Chairman Jerome Powell and many formally dovish members such as Neel Kashkari.

The Employment Cost Index, which measures changes in employee compensation costs including wages, bonuses, and indirect costs such as social security, training, medical benefits, and taxes, was up 1% for the 4th quarter making 4% for the year. As the Wall Street Journal pointed out, that number has not exceeded 4% since 2001.

Employment Cost Index

Just wages and benefits increased 4.7% in December. Simply put, workers are demanding higher wages to offset rising prices for items like food, rent, gas, utilities, etc.

That 4.7% does not keep pace with rising costs. The PCE (Personal Consumption Expenditure Deflator, which tracks overall price changes for goods and services purchased by consumers increased 4.9% in December, above expectations.

PCE Deflator for December

That 4.9% PCE number excludes food and energy. PCE including food and energy rose 5.8%, the highest level since 1982. Anyone who has paid a utility bill, filled their car with gasoline or gone to the grocery store would be loath to exclude food and energy costs.

PCE Including Food and Energy

Acknowledging that it’s anecdotal, Kraft Heinz Co. (KHC) recently announced 4-5% price increases across its portfolio of products with some products like Velveeta and Oscar Meyer hotdogs seeing 6.6% and 10% respectively. For those who continue to insist that inflation is “transitory”, (a notion I debunked in an October article “Inflation Update: It’s Not Transitory”) Kraft said that Americans need to get used to higher food prices.

While consumers see the end of the line price increases at the supermarket, companies like Kraft have been feeling the effects of commodity price increases for months. As I wrote in my first inflation article in August, one only needs to look at the prices of base commodities such as soybeans and natural gas. Most people don’t realize it, but the prices of these two commodities drive so much of the costs of our daily lives.

Natural Gas:

Natural gas’s most noticeable impact on most people’s wallets might be their utility bill. Many regulated utilities price their generating costs off the price of natural gas. Regulators simply allow the utilities to pass through the price of the feedstock to customers. As natural gas prices rise, utility bills rise. A lesser known impact of natural gas pricing is the cost of fertilizer.

Nitrogen is the most prevalent fertilizer used in the US (and probably the world) today.

Fertilizer Use Per Acre

Nitrogen fertilizer is made using the Haber-Bosch process, which combines atmospheric nitrogen with hydrogen gas to form ammonia. The hydrogen gas used for this process is usually obtained from methane derived from natural gas or other fossil fuels. Therefore, higher natural gas prices means higher fertilizer prices which means farmers have to receive higher prices for their crops or risk going out of business. Farmers are raising the prices. Soybeans are a prime example.

Soybean Prices

I can’t stress strongly enough how many foods contain soybeans somewhere in their production chain. Go to the supermarket and look at the ingredients at almost any random box and chances are you’ll see soybeans or a derivative/processed form (typically Soybean Oil or Lecithin). Not surprising both are at extreme multi-year highs.

Soybean Oil

Lecithin

There are other supply and demand forces driving the prices of soybeans and their derivatives. Some poor harvests in places like Argentina and Brazil are partially to blame on the supply side. Certainly, harvests are cyclical and can reverse. Higher demand from places like China which changed its pig feed policy following Africa Swine Flu outbreak is a cause as is the rise of renewable diesel refining which using millions of tons of soybeans every year. I believe those two demand factors are structural and unlikely to change any time soon. Still, fertilizers comprise about 15% of a farmer’s costs. Higher natural gas drives those costs higher.

It is not just natural gas prices here. European natural gas prices are at crisis levels.

Netherlands Natural Gas Forward Month In Euros

About 10% of the world’s fertilizer is produced in Europe. Those fertilizer plants simply have to shut down at these natural gas prices. A 10% reduction in supply of almost any commodity can lead to much higher than 10% increase in prices.

The Result:

Rising prices at the pump and the supermarket (plus higher housing costs) and plenty of job openings have naturally translated to higher wages. Workers simply will demand to be paid more given the demand for their services and the costs of living they face. This dynamic has gone from pretty benign this time last year to levels we haven’t seen in 40 years rather quickly. The Federal Reserve’s response is going to be tighter monetary policy. I question whether higher interest rates will solve the natural gas and food price issues.

Conclusion:

I have been arguing since August that inflation is a major issue and unlikely to be solved any time soon. One only has to watch soybean and natural gas prices to keep tabs on it. For that reason, I continue to like agricultural plays such as Archer-Daniels (ADM), Bunge (BG), fertilizer plays such as CF Industries (CF) and Mosaic (MOS) and natural gas plays such as EQT Corp. (EQT), Enterprise Products (EPD), Crestwood (CEQP), Chesapeake (NASDAQ:CHK) and California Resources (CRC). I have written about many of the above companies if anyone wants more detail on them.