The economy , markets and inflation

Demand destruction. Demand destruction. Demand destruction.

That is all one seemed to hear from analysts and managers for months as food and energy prices soared. But now that we are actually seeing demand destruction, no one seems to recognize it.

Yes, much of the May drop in auto sales was due to supply chain interruptions. But the bulk of the other economic weakness is due to higher inflation generating weak income and demand growth. Over the past six months the monthly change in real average weekly earnings has been:

Nov. Dec. Jan. Feb. Mar. Apr.

-0.1 -0.6 -0.3 -0.0 -0.7 -0.2

The change in real personal income excluding transfers, the single best determinate of consumer spending, has been:

Nov. Dec. Jan. Feb. Mar. Apr.

0.1 0.2 1.1 0.0 -0.1 0.1

The January 1.0% jump was due largely to the payroll tax cut.

Given this weakness in real income, it should be no surprise that consumer spending and the economy has weakened.

Real average weekly earnings growth is a leading indicator much like the stock market in that it has forecast 10 of the last seven recessions. But every recessions was accompanied by falling real weekly earnings.

The consensus still is calling for significantly higher growth in the second half. But this depends on weak food and energy prices allowing real incomes to expand. Over the last month commodity prices have weakened and this is encouraging for the inflation outlook. But so far the commodity price weakness looks more like a correction than a trend change. Oil prices in particular have not broken cleanly below $100 and Brent crude is still above $110. Copper, aluminum and other metals prices have yet to break below their 12 month moving average and their current drop is not out of line with past corrections, as in early 2010. Meat prices have fallen sharply, but grain and soybean prices are still near their record highs. Cotton prices, for example, are still well above their year-end level.

What demand destruction is really about is firms ability to pass higher cost through to the final consumer. Corporate managements and analysts have assumed in their earnings forecast that firms will have no trouble realizing higher prices. In an inflationary spiral this is a safe assumption. But demand destruction implies that we are not in an inflationary spiral