Price elasticity

As m* watches the inexorable rise of dollar priced items apparently not in the official scorekeeper's core consumption basket, a few recent news items brought to mind that the law of supply and demand is not a direct driver of prices but is mediated through a sometimes direct but also sometimes vague transmission known as elasticity.

George Anders page one piece in last week's pre-Murdoch WSJ on Linear Technologies very nicely demonstrates that for small items like a component who's cost makes up just a few percent of the overall cost of a finished product, price elasticity can be quite low. However in a highly competitive marketplace with many substitute products and producers low price elasticity and high profitability is a short lived and highly cyclical moving target.

However in the less competitive marketplace for let's say, industrial commodities, where the supply elasticities are very low and substitutes hard to come by, steadily rising prices (and astronomical profits) have been the norm as globalization and BRIC industrialization kicked into high gear. And yet official policy towards these price increases has been very similar to that of Linear Technologies customers. While the prices for these materials has increased, they make up an increasingly smaller component of our increasingly service based economy and are therefore tolerably inconsequential to our overall price picture.

Which brings us to the second item, Zavier Blas's FT reports on the apparently changing price elasticity for oil. It is now widely understood, if we take the IEA figures as correct, that growth in oil demand of between 1.5% and 2 % annually is outstripping a supply appearing ever more fixed at perhaps 1% on a good day, even as the price continues to march higher. I am reminded of the debate a few years ago as oil first went from the 20's to the 40's and beyond about what price level would induce the SUV loving US consumer to finally curtail the MEW spending binge. Well, we are finally seeing weakness in real retail spending, but given the rather more dramatic pressure of rising home mortgage resets and stagnant or falling home prices (and thus a shift to more expensive revolving consumer credit) I am not sure we can yet pin this on higher oil prices.

I bring this up only because our official scorekeeper does not include the price of oil in its "core" inflation measuring basket and yet, I do not think it is a secret that it's own forecasts for lower inflation going forward are predicated on higher energy prices slowing down the economy (leading to lower energy prices). Ah me, this is the sort of dancing required of a central banker these days to keep the whole mess of plates in the air and still spinning.

Back to elasticities for a minute, a gallon of gasoline in London is well north of $8 a gallon and the economy there (as everywhere really) is running much stronger than the inflation-targeting but blessedly reality based central authorities deem healthy. Theory says that a one-time price rise is not inflationary - that relative prices adjust and that is that. But theory also depends on stable inflationary expectations. And therin lies the rub.

It is all in the speed of the adjustment of course (that elasticity again) but as you fill up your tank and dip your Amex for another $85 that could easily be, say, $170 consider that CNBC's latest Trillion Dollar survey shows 80% of managers believe the Fed's next move will be a rate cut. I am not saying it wont but I am pretty sure the bet for now is the other way.