Inflation Remains Low In February

During February, the US economy posted zero percent inflation due, in large part, to falling costs for energy and apparel. In keeping with trends already in progress, health care and education costs continued to climb, and the year-over-year inflation rate was 2.2 percent. See the following post from The Mess That Greenspan Made.

The Labor Department reported zero inflation for the month of February as rising prices for medical care and education were offset by sharply lower costs for energy and apparel. This comes after a 0.2 percent increase in January and marks the eleventh straight month that the price index did not drop after a series of steep declines beginning in late-2008.



On a year-over-year basis, the overall consumer price index was up 2.2 percent following an annual gain of 2.7 percent the month before, however, we may not have seen the last of rising annual inflation as recently higher gasoline prices are not reflected in the most recent data.

By category, it was a familiar story as health care and education costs continued their relentless advance while prices for many other goods again fell. The closely watched shelter component (within the housing category) was flat in February after a decline of 0.5 percent last month and is now down 0.4 percent on a year-over-year basis.


Energy prices were down 0.5 percent in February after an increase of 2.8 percent the month prior and are now 14.4 percent higher than a year ago. Last month, gasoline prices fell 1.4 percent but they are still almost 37 percent higher than last year at this time.

Recall that gasoline prices did not move much above the $2 a gallon mark last year until May, so there will be a few more months of big energy price increases in the period ahead.

This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Ben Bernanke's Exit Strategy Dilemma

The newly reappointed Fed Chairman Bernanke faces a dilemma of whether to keep interest rates low and risk inflation following the massive influx of money into the financial system or to increase interest rates and risk ending the economic recovery. Strong political pressure to create jobs and the currently tame inflation projections will favor the former as the likely choice. See the following post from The Capital Spectator.

Fed Chairman Ben Bernanke will be chatting up the central bank’s exit strategy later this week when he testifies before the House Financial Services Committee on February 10. To say that there are political and economic risks hovering over the subject is to understate the potential hazards.

There are risks to tightening too early, which some worry would repeat the mistakes of 1936-1937, when reserve requirements were tightened and the economy slipped into recession. At the same time, it'd be foolish to discount the potential for higher inflation in the years ahead in the wake of the extraordinary monetary stimulus over the past year or so. Regardless of the economic reality, the political pressure to keep rates low is intense, given the weak labor market.

In late-January, Carnegie Mellon Professor Alan Meltzer bluntly responded to Bernanke’s commentary on the details of an exit strategy by opining that the Fed chairman’s plan is destined to fail. Meltzer, author of a sweeping two-volume history of the Fed (A History of the Federal Reserve, Volume 1: 1913-1951 and A History of the Federal Reserve, Volume 2, 1970-1986), said that Bernanke's plan to prevent future inflation is "incomplete." As Meltzer explains, "The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation. I don't believe this will work, and no one else should."

Will Ben respond to the criticism and soothe Meltzer's concerns? Stay tuned. For the moment, however, the stakes are low, or so the market outlook for inflation suggests. The Treasury market's 10-year inflation forecast is a modest 2.27%, based on the spread between the nominal and inflation-indexed 10-year Treasuries as of Friday's close.

That's roughly in line with the inflation outlook just before all hell broke loose in September 2008, when Lehman Brothers failed and the financial troubles at the time exploded into a crisis. Among the fallout from the chain of events that month was the heightened risk of deflation. Judging by the market's forecast these days, the deflation risk has faded. Yet the inflation risk at the moment looks tame.

No wonder that the Fed funds futures market anticipates no imminent change in short term rates. If we look out a year, the futures market expects the Fed to raise interest rates, but just barely. The February 2011 contract is currently priced for a roughly 0.75% Fed funds. That's up from the current 0-0.25% target range, but as changes in rate expectations go, that's rather subdued.

Will Ben's testimony on Thursday give us reason to rethink the future of inflation and interest rates?

This post has been republished from James Picerno's blog, The Capital Spectator.

Inflation Back To Normal Levels

The inflation rate has risen to more typical levels after being in negative territory during the Summer. The numbers, which may be distorted by the substantial rise of gas price from its low of $1.60 a gallon last December, shows that the Fed may deserve credit for doing something right. See the following post from The Mess That Greenspan Made.

The Labor Department reported that rising energy costs drove consumer prices 0.4 percent higher in November following a gain of 0.3 percent in October and, on a year-over-year basis, the official rate of inflation in the U.S. now stands at 1.8 percent.



This is a far cry from the negative annual rates of inflation reported over the summer, rates that reached a low of -1.9 percent in July at the peak of the negative year-over-year energy price comparisons.

Of course, during the second half of 2008, energy prices tumbled, so, instead of comparing to 2008 gasoline that cost over $4.00 a gallon in July, those comparisons are now being made against $2.00 a gallon prices in November.

Recall that energy prices continued to decline through the end of last year, gasoline reaching a low of about $1.60 a gallon in mid-December, so the year-over-year increase in energy prices to be reported next month will be even more extreme.

Last month, energy costs rose 4.1 percent, the sharpest increase since August, and are now up 7.4 percent from a year ago. Gasoline prices jumped 6.4 percent in November and are almost 24 percent higher than last year at this time.

But, it's not just energy prices that are rising as medical costs continue to increase at a healthy pace, up 0.3 percent last month and 3.5 percent from a year ago as shown below.




Unfortunately, for those thinking that we're headed for a repeat of 1970s style inflation, with rent and owners' equivalent rent (the government's poor proxy for home ownership costs) accounting for almost a third of the overall price index, that's not likely to happen anytime soon.

The shelter component of price index (within the housing category) now seems to be completely broken, but in a good way if you're in favor of reporting only modest changes to consumer prices. As rents nationwide continue to fall, the Labor Department shows them rising by about one percent over the last year. This follows years of annual increases of about two percent when the housing bubble was in full swing and home prices were rising by 8, 10, or 12 percent per year.

Of course, most economists will point to today's "core" rate of inflation - where the broken shelter component accounts for a whopping 40 percent of the index instead of just 30 percent - and then claim that prices are stable.

Compared with a year earlier, consumer prices excluding food and energy were up 1.7 percent in November, matching the year-over-year gain in October. In fact, judging by the "core" rate of inflation - a measure that has not strayed beyond the one percent to three percent range for the entire decade - you'd have to think that the central bank has done an outstanding job in keeping prices in line.

If only they could have done as good a job at keeping asset bubbles in line...

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Bernanke Maintains That Inflation Is Under Control

Moses Kim argues that inflation is a clear and present danger, while Bernanke maintains that inflation is subdued. Kim points to historical examples to support why the stimulus money that was pumped into the economy and lower interest rates, in addition other market factors, will lead to inevitable inflation. See the following post from Expected Returns.

From Bloomberg, Producer Prices in U.S. Climbed More than Forecast:

Wholesale prices in the U.S. increased more than anticipated in November, led by a jump in fuel costs and a rebound in truck prices.

The 1.8 percent increase in prices paid to factories, farmers and other producers was more than twice as large as anticipated and followed a 0.3 percent gain in October, according to Labor Department data released today in Washington. Excluding food and fuel, so-called core prices also exceeded the median estimate of economists surveyed by Bloomberg News.

According to Bernanke, inflation is not something to worry about in the near future. Well it looks like inflation is already here. Since crude oil prices are roughly double depressed levels from a year ago, expect inflation to remain elevated moving forward. Expect more jawboning from clueless Fed officials as our economy enters the abyss once again.

Fallacy of "Spare Capacity"

Near-record excess capacity and a jobless rate that is projected to average 10 percent in 2010 may prevent suppliers from passing on a rebound in commodity costs even as the economy recovers. Federal Reserve policy makers, meeting this week, have said they expect inflation to remain “subdued” in coming months, allowing them to keep interest rates low.

“Competition is brutal,” said Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc., a New York forecasting firm, who forecast producer prices would rise 1.2 percent. “If somebody raises their prices, someone else won’t. We’re squarely in the disinflationary camp. There is way too much spare capacity.”

It's clear Keynesianism is alive and well in America. Keynes justified lower interest rates by saying that it would induce investment and utilize spare capacity. Inflationary pressures were therefore likely to be subdued, since output would rise along with the money supply.

Now, if this theory actually worked in real life, then there would have been no stagflation in America in the 1970's. The 1970's in America, marked by high inflation and depressed economic activity ("spare capacity"), should have been empirical proof of the fallacy of Keynesian theory. Market prices are always signaling something about the economy and the dynamic of supply and demand. If businessmen are hesitant to invest at market interest rates, then there is probably a reason. Lowering interest rates merely promotes speculation and reduces productivity across the board. Governments and businessmen alike engage in projects that are not justifiable. Indeed, Keynesian proponents are thinking at a 2nd grade level.

Alan Greenspan: Bernanke Out of Bullets

Now that Alan Greenspan has left the Fed, he is a lot more honest with his economic analysis. Although he led us to the cliff, Bernanke is pushing us off of it. In a recent interview, Greenspan said:

"I think the Fed has done an extraordinary job and it's done a huge amount (to bolster employment). There's just so much monetary policy and the central bank can do. And I think they've gone to their limits, at this particular stage," Greenspan said on NBC's "Meet the Press."

"You cannot ask a central bank to do more than it is capable of without very dire consequences," Greenspan continued, saying the United States faced a serious long-term threat of inflation unless the Fed begins to pull back "all the stimulus it put into the economy."

With his back against the wall, it's pretty clear Ben Bernanke will bring out the helicopters and flood the world with worthless dollars, thereby putting the final nail in the coffin to our economy. It's ironic that a supposed expert on the Great Depression is setting in place policy that will guarantee another depression in America.

There will be dramatic consequences in the near future due to the easy money policies of Bernanke, and the crony capitalism that has overtaken America. Economic shocks are likely to come suddenly and without warning, which is why times of relative calm should be used to prepare for the storm. No one passed out a memo to citizens of Iceland warning about a 90% crash in stock markets and a steep devaluation of the krona. Ask Icelandic citizens what they would have done differently, and I guarantee you most would have wished they held gold. I think it would be wise for all American citizens to consider doing the same.

This post has been republished from Moses Kim's blog, Expected Returns.

Expectations Of Inflation Are Growing

It appears that neither deflation nor inflation are currently a problem with the consumer price index barely moving in either direction. However, the outlook for inflation based on the daily yield spread is growing, which when considered with rising gold and declining dollar, is raising market expectations of future inflation. See the following post from The Capital Spectator.
One of the supporting pillars in the recent rally is the recognition that inflation isn't a problem. Last year's financial crisis knocked the stuffing out of the system's tendency to devalue the purchasing power of fiat currencies over time. The net result is an unusual level of economic cover for keeping interest rates low--really low. Indeed, the primary goal of the Federal Reserve and its counterparts around the world over the past year has been the unbridled pursuit of higher inflation, though not necessarily high inflation.

In the depths of the crisis, the immediate objective was simply to deliver some level of inflation, which is to say something other than deflation. Allowing deflation to fester is simply too great a threat. The basic prescription has been printing money. How's it working?

The good news is that deflation is no longer a clear and present danger, as it appeared to be late last year and into early 2009. Measured by the consumer price index (CPI), the official benchmark of inflation in the U.S., the last monthly decline in consumer prices overall was in March. There have been two months with flat prices, but the general trend since the spring is up, if only marginally. In September (the last reported month), CPI advanced 0.2%, down from August's 0.4% rise, the Labor Department reported. The latest CPI reading shows that consumer prices fell on a year-over-year basis, but that statistical quirk will soon fall away as we move beyond the events of 2008.

The October update on CPI arrives next week (November 18), and the consensus forecast is looking for a 0.2% rise, according to Briefing.com—unchanged from September.

Meantime, the Treasury market's outlook for inflation is climbing. As our chart below shows, the implied outlook for inflation based on the spread between nominal and inflation-indexed 10-year Treasuries is now above 2%. This is the first sustained move above 2% since the financial crisis of 2008, save for a brief rise over this level back in June.



A 2% inflation rate is hardly the end of the world, of course, assuming the forecast proves accurate. Indeed, before last year's crisis, the Treasury market was consistently predicting inflation in the 2.5% range. By that benchmark, the inflation outlook remains muted. Much of the recent rise is simply a return to levels that prevailed under less extraordinary times.

But expected inflation is a slippery concept, as is all other efforts at divining the future. What's more, there's no lone methodology for forecasting inflation, much less one that's persistently accurate. Rather, the crowd is constantly reassessing the future and making guesstimates about what's coming. But while we can debate exactly what constitutes a fair outlook for pricing pressures, the general trend is clear, as the chart above shows. Slowly but surely the market is raising its inflation expectation.

There's some corroborating evidence that this is more than rank speculation. The gold market, for instance, has been pushing higher too. An ounce of gold now trades for roughly $1,100, a roughly 50% rise from a year ago. Meantime, the U.S. dollar has weakened over the past year. The twin trends suggest that inflation is on the rise, if only marginally.

That's no surprise, given the Fed's instinct and decisions over the past year. But in pulling the levers that engineer a higher level of inflation, the great question is whether Bernanke and company can slow and/or turn off the upward momentum in pricing pressure at the appointed time?

One of the Fed's own, James Bullard, president of the St. Louis Fed, tells FT yesterday that for the foreseeable future “you have inflation that will be possibly substantially above target over a horizon of two to four years, and that, I think, is because of the combination of very large fiscal deficits in the US with very easy monetary policy.”

We keep hearing that the central bank shouldn't repeat the mistake of the 1930s, when the Fed started raising interest rates too early, which derailed the nascent recovery. But it's becoming clear that the problems of the moment don't constitute another Great Depression. There are still huge challenges ahead, but they're different challenges than those that confronted policymakers in the mid-to-late 1930s. Nor is it clear that interest rates just above zero are the magic solution to what ails us now.

One can make a case that it was easy money that got us into the current mess and that easy money isn't necessarily going to get us out of the hole this time, as it seemed to in past business cycles. Yes, stabilizing the system was a priority over the past year, starting with preventing deflation. That battle seems to be won. Deciding what comes next, and what it means for portfolio strategy, is now the topic du jour, and it's only just begun. Unfortunately, easy answers aren't forthcoming.

As the FT story on Bullard advises,

Mr Bullard said historically the Fed had waited until two-and-a-half to three years after a recession ended before raising rates. That, he said, “would put you in the first half of 2012”. But the committee might take into account a wider set of factors this time, including the danger that ultra-low rates could fuel asset price bubbles.

“What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: ‘What does the output gap look like; what does inflation look like?’”

This post has been republished from James Picerno's blog, The Capital Spectator.

Inflation Of Domestic Versus Overseas Goods And Services

Tim Iacono from The Mess That Greenspan Made, breaks down inflation into domestic inflation and imported inflation and comes to an interesting conclusion. The deflation of goods and services from overseas has made overall inflation appear lower than it really is. If you look at domestic inflation in isolation, it shows much higher inflation than the public has been led to believe.

For some time now, the disparity between price increases for imported goods and price increases for domestic goods and services has been of great interest to me and, after working through all of the applicable Labor Department data on this subject, it quickly becomes clear that there is an interesting story to tell here about two very different types of U.S. inflation in recent years - domestic inflation and imported inflation.



The data in the graphic above will be detailed in the paragraphs ahead because it is deserving of close inspection. To be sure, it is a quite fascinating subject for those not familiar with how dramatically inflation in the U.S. has changed over the years.

But, the more important point to be made here first is that this disparity between domestic and imported inflation was one of the primary reasons why central bank policy in the U.S. had been steering us on a wayward course for so many years. Clearly, two of the major factors that enabled the nation's "easy money" policies for the past two decades have been:

1. The fixation on consumer prices (while ignoring asset prices)
2. The irrational fear of falling prices (today and in 2002-2003)

To a large extent, the Holy Grail of benign inflation and the threat of deflation were not what they appeared to be. In short, the deceptive combination of sharply rising domestic prices combined with falling prices for imported goods has been a major contributor to policy mistakes by the central bank, one of many policy mistakes made over the years that have now come home to roost.

Breaking the Consumer Price Index Apart

The Labor Department breaks consumer prices down into eight major categories, weighted as shown below. This composition is intended to represent a "basket of goods" that consumers purchase and the overall, weighted increases in prices are intended to represent the "rate of inflation" in the U.S.



For the purposes of this discussion and as the source for all the charts that appear here, only original Labor Department data is used and all issues related to such things as hedonic adjustments, geometric weighting, and other factors that contribute to the "reported" rate of inflation almost always coming in lower than the rate of inflation experienced in the "real" world will be ignored.

Importantly, lower "reported" inflation goes a long way in limiting government liabilities for such things as cost of living adjustments and makes central bankers, the stewards of American fiat money, look better than they otherwise might, so, this is not a subject that should be dismissed as inconsequential because, clearly, it is not.

It just won't be part of this discussion.

As for separating the consumer price index (CPI) into "domestic" and "imported" components, in looking at the top-level categories above, one can clearly spot a few that are predominantly domestic - education/communication, food/beverages, and medical care - and, while there are surely some imported goods in each of these groups (e.g., the 0.214 percent weighting for personal computers within the first group), it can safely be said that the "domestic" label fits all three.

Similarly, since the U.S. essentially stopped making their own clothes years ago, it can safely be said that the apparel category consists of primarily imported goods.

But, after that, things get a little trickier.

Making Sense of the Housing and Other Categories

The housing category breaks down as shown below and, as noted here many times before, probably the single biggest blunder of all regarding the consumer price index was the substitution of "owners' equivalent rent" for the cost of homeownership back in 1983.


As far as monetary policy is concerned, this was one of the major "enablers" for the late great housing bubble and its subsequent bursting since there would have been little chance of short-term lending rates resting at one percent back in 2003 and 2004 if home prices that were rising at an annual the rate of eight to ten percent nationally had been included in the calculation of consumer prices rather than the dubious measure of what homeowners think their place might rent for.

In fact, owners' equivalent rent has so distorted consumer prices in the U.S. that they, along with rental costs within the "Shelter" subcategory of the CPI, are completely excluded from the domestic/imported inflation discussion here.

[Note: For a complete breakdown of the CPI categories see this item at the BLS.]

With rents excluded from this list you are left with one sub-category of goods that is mostly imported - household furnishings - and the rest can be safely categorized as domestic.

Moving on to the transportation category we find cars, trucks, and the fuel that is required to run them and, while these are clearly both domestic and imported goods, the task of separating the two is nearly impossible. Since they are primarily made in the U.S., for the purposes of this discussion they are considered domestic.

Similarly, the recreation and other goods and services categories contain a mix of products, however, here they can be easily segregated. For example, nearly all cameras and audio equipment are imported while movie tickets and film processing are domestic services. And in the final "other"category, tobacco products are clearly home grown while personal care products are largely imported.

Prices for Imported Goods are Falling Faster Than you Think

Lo and behold, when only looking at products that are imported (mostly from Asia), one sees that we've had "deflation" for quite a few years now and not just the "one-off" variety where readings come in at minus one percent and persist for only a month at a time.

For example, the apparel category has posted year-over-year price declines in 13 of the last 14 years and clothes cost a cumulative 15 percent less than they did in the 1990s.



Now that's what I call "deflation", though, it has more to do with cheap labor and fixed exchanged rates in Asia than it does with anything else.

Prices for most imported goods have been declining consistently over the last decade, however, you don't hear too much about this as most news reports and analysts cite the headline inflation numbers or, worse, "core" inflation, excluding food and energy.

Falling prices for imported goods have been a key factor in being able to report overall "moderate" rates of inflation in recent years.

Prices for Domestic Goods and Services are Quite High

On the domestic side, when looking past the volatility that somewhat obscures the underlying pattern in the chart below, prices are clearly rising much faster than headline inflation has been indicating, particularly since the turn of the century.

[Note: The scales are the same for the chart below and the one in the previous section in order that the magnitudes can be more easily compared.]



While food price have been rising only modestly up until last year, it probably won't come as a surprise to anyone to learn that medical services costs have more than doubled over the same period of time that apparel prices have plunged, as noted in the previous section.

It is not until you look closely at the individual components of the consumer price index that you realize we really have been living in a world of "two inflations" - tumbling prices for imported goods and rapidly rising prices for domestic goods and services.

Combine these two inflations and throw in the huge "shelter" component that neither rises nor falls much as home prices soar and then plunge and the result is "benign" inflation.

What Does this all Mean?

For years, persistently low and falling prices for imported goods such as electronics and apparel have been masking much higher levels of domestic inflation in areas such as medical services and household energy.

Any economist with a spreadsheet and a web browser could have confirmed that.

But, what is significant about this is that this phenomenon should have been factored into monetary policy over the last decade or so but it wasn't.

Low inflation, regardless of its source, was used as a justification for keeping interest rates too low for too long and the unfounded fear of "de-flation" was the reason cited for keeping rates at "freakishly" low levels for several years in this decade.

Yes, pegged currencies in Asia play a role here, but surely the folks at the Federal Reserve, even with their misguided focus on consumer prices to the exclusion of nearly all other considerations, could have seen that inflation in the U.S. was only as low as it was because of cheap imports.

Had this been understood and had interest rates been kept higher over the last ten years, we probably wouldn't have near the number of problems that we've seen in the last year or two.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

How The Inflation Monster Could Spoil The Party

The stock market has rallied, job losses are cooling down, and housing prices swung higher this summer. Just when it seemed like we might make it out of the recession, the inflation monster may arrive with a vengeance. Tim Iacono explains why multiple factors may conspire to summon the inflation monster in the not-so-distant future.

You hear a lot of talk these days about what could possibly stop the current stock market rally given that we've clearly passed the "acute" phase of the financial crisis and, quite literally, there is no place to go but up for many economic indicators.

The term "statistical recovery" is bandied about quite a bit by doubters of the recent move up for equities and for many very good reasons such as the following:

• home prices seem to be going up when they're probably really still going down
• consumers have dramatically cut back on their spending but no one seems to care
• current quarter GDP will print at +2 or +3 percent but it is completely unsustainable
• bank balance sheets appear healthy when they are really still loaded with bad loans

But, none of this really seems to matter when you have a chart that looks like this.




A 50+ percent move up over a period of five-and-a-half months will eventually make a believer out of almost anyone, a point that is proven again and again, day after day.

But, aside from some big new financial market brush fire developing somewhere that, having learned the lessons of 2008 well, the Treasury Department and Federal Reserve will no doubt quickly hose down with another few hundred billion dollars in money and credit (more if needed), is there anything out there on the horizon that might dampen the enthusiasm of the stock-buying public?

Well, the obvious one is housing.

While a growing number of pundits have all but declared the housing market healed, the latest evidence being offered the other day in the S&P Case Shiller Home Price Index, there is still clearly a ways to go before real estate stops being a drag on consumer psyches and far too many still believe that, somehow, we'll revert to our 2005 spendthrift ways.

There are millions of foreclosures still to come over the next year or two and most people seem all too willing to take their $8,000 tax credit and bid on a property, not seeming to know or care that home price bottoms are long drawn out affairs and that five percent 30-year fixed rates are the exception, not the rule.

As for the Case Shiller Home Price Index, as noted here previously, there's a pretty good chance that seasonal factors will result in the resumption of negative monthly price changes in another few months, though, with the sea-change in prices recently, anything could happen.



The reversal in home prices from a February-March decline of more than two percent to a May-June gain of almost 1.5 percent was the largest three-month swing in more than 20 years of data for the 10-city index - more than double the previous record.

Is that what's really happening in the housing market and, if so, how long can that possibly continue with the deluge of sellers that will now be entering the market, most importantly banks with their huge inventory of foreclosed homes?

Another month or two of rising home prices and then a swift return to negative numbers could dampen confidence very quickly later this year and millions of shareholders might realize that home prices have not yet hit bottom, despite the optimism everyone felt over the summer.

Turning to the labor market picture, it remains a bleak outpost where stock market bears can still gather to compare notes, however, it is not likely to scare off any bulls at this point.

Who would have thought that we'd ever "cheer" a quarter of a million jobs lost in just one month? But, that's what happened last month and it might happen again next week.

There is much more pain to come in the labor market but, from here on out, except for the low-profile, long-term unemployment statistics, it will continue to be a case of being "less bad" than what we've already seen.

In a world where "less bad is the new good", that's reason alone to bid stocks higher.

There is one thing, however, that could put the kibosh on investors' enthusiasm a few months down the road - inflation.

Inflation?

Hasn't inflation morphed into deflation - an annual rate of minus 2.1 percent as of July - and isn't everyone looking for consumer prices to be tame for the next year or two if, as it appears now, we are lucky enough to avoid that dreaded Great Depression malady of "de-flation"?

Surely, the now-docile CPI won't be spooking any shareholders this year.

Well, maybe it will...

Here's why.

Recall that the consumer price index breaks down into eight major categories as shown below, the two categories that contain energy costs - housing and transportation - both broken out into energy and non-energy components.

Here's the way things stand today, energy prices being the clear driver in the current negative annual rate of inflation which reached a 50+ year low last month.



Notice that, even through the distortion of hedonic adjustments and other nefarious measures that the Bureau of Labor Statistics uses to ensure that prices don't rise too much, nearly all non-energy categories are still up from a year ago, some of them a lot.

Though economists may still favor the dubious "core rate" of inflation, it is the year-over-year change in the "overall" rate of inflation that garners all the headlines and elicits concerned looks from investors of all stripes.

So, what happens later this year when, instead of comparing energy prices against $140 crude oil or even $100 crude oil, energy costs are compared to $40 or $50 crude oil?

Well, it may not be pretty.

Even though all energy components account for less than eight percent of the overall index, they have quite a large impact on the headline figure when you get changes of 30, 40, 50 percent or more and, importantly, this works in both directions.

According to Energy Department data, U.S. gasoline prices reached a low at about $1.61 a gallon last December and stayed below $2 a gallon until the spring. Today's average retail price of $2.62 represents a whopping 63 percent increase over last year's low, a full 30 percent above the two dollar mark. With the prospect that crude oil prices may not go down and, perhaps, might just head toward $100 a barrel between now and the end of the year, this sets the stage for some surprisingly high inflation rates.

Keeping all other categories in the CPI unchanged from year-over-year readings and throwing in a healthy increase for heating oil, piped gas, and electricity (which is something of a stretch for natural gas prices, but, anything's possible these days), all of a sudden you come up with three or four percent inflation again before Christmas, perhaps higher.



After the huge success of the Cash for Clunkers program, many now expect car prices to rise which could push that last red bar hanging below the x-axis into positive territory.

Now, I don't know about you, but it seems to me that inflation rates this high might set off all sorts of chain reactions in financial markets, especially with interest rates at zero percent and the Fed printing money furiously, and none of this is likely to be good for equity markets.

As the world learned painfully in the 1970s, stocks and inflation don't get along too well together and, while this surge in consumer prices might only last four or five months, it will nonetheless have the media talking about inflation again and those poor seniors who are getting no cost of living adjustments in their Social Security checks will again be calling their Congressmen to complain.

Believe it or not, a curve like the one you see below is quite possible as we enter 2010.



Now, the really bad news here is that, since the recent wave of liquidity has pumped up nearly every asset class, the price of oil is not likely to go down (making for tame inflation later this year) unless stock prices go down.

But, based on the much higher year-over-year rates of inflation that will show up later this year if oil prices do not go down, that, in itself may be enough to send the price of stocks down.

Either way, it looks like something has to go down.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Deflation Risk Averted But Could Massive Inflation Be Around The Corner?

By creating nearly $4 trillion in new money and credit, representing the largest increase by the American federal government since the country's Civil War, the monetary system has been repaired and deflation is no longer an imminent risk. But a lack of political will and continued annual deficits in excess of $1 trillion through 2016, along with significant pressures in the economy, could likely lead to broad inflation over the next two years, with gold and strategic assets offering potential shelter from the expected storm. Porter Stansberry from Daily Wealth discusses this below.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

For most of 2009, I've had a friendly disagreement with several colleagues who believe a big deflation will be the end result of the 2008 financial crisis.

I knew they were wrong. I knew inflation would become a problem sooner, rather than later. And in the past several months, I've been proven right.

The mortgage and banking collapse of 2007-2009 saw total collateral values collapse between $5 trillion and $10 trillion. The response from our politicians and central bankers was massive: the largest creation of new money in credit since the Civil War.

The Federal Reserve created roughly $2 trillion in additional credit and loaned it against all kinds of dubious collateral, things like Bear Stearns' mortgage book. (There's a handy and simple guide to estimating the Fed's credit quality. The more acronyms in the lending programs, the worse it gets.)

The Federal government responded with a record annual deficit of at least $1.8 trillion. In the second half of 2008, the outstanding federal debt grew by roughly a 40% annualized pace (24% for the entire year). Thus, in only a few months' time, the roots – the money and credit – underlying our economy expanded at a record pace.

In the second half of last year and the first quarter of 2009, the main question in the world's financial markets was: Can the world's government print enough money, fast enough, to forestall a deflationary collapse?

I knew it was no contest. There is no way for an economy to outrun a printing press. The Fed has the power to create an unlimited amount of money or credit and the power to inject that money into the economy in any way it sees fit.

Let's look at the numbers. Let's assume the total collateral damage of the banking crisis turns out to be $5 trillion. Yes, that's a huge hit – roughly half the output of our economy each year. It's the equivalent of sending every American household a bill for $50,000 – due immediately. However, in less than a year, the Feds have already created nearly $4 trillion in new money and credit. The hole in the system has already been plugged. It only took a few months.

The fight between inflation and deflation is over. Deflation was knocked out in the first round.

The big risk is what happens next. Having turned on the presses to save the day, who will have the political clout and the desire to shut them off? Barack Obama's budget calls for annual deficits in excess of $1 trillion for the next eight years. Thus, by the end of this year, not only will all of the damage from the mortgage collapse ($5 trillion) be replaced by new money and credit, there will be significant inflationary pressures in the economy.

The good news in our economy this year, so soon after such a major collapse, means we will certainly have a massive inflation during 2010 and 2011. There's no such thing as a free ride. Bailing out the banks will carry a heavy price for anyone who doesn't have the resources or the knowledge to escape the dollar.

How can you "escape"? First off, make sure you own plenty of gold bullion. I also recommend owning assets that will run higher in an inflationary environment, like vital transportation and energy assets. Also, own some good farmland. Food and land prices will go higher.

Yes, the news is grim... but if you own gold and strategic assets, you'll survive and prosper in the coming inflation.

This article has been republished from Daily Wealth, a contrarian investment analysis and advice site.

Ben Bernanke's Plan To Prevent Inflation

Ben Bernanke outlined his plan to prevent inflation in an article in the Wall Street Journal. While this plan sounds good on paper, economist Mark Thoma from Economist's View warns that the Fed can not raise interest rates too soon and risk sending the economy back into recession. See the following post on this topic.

Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

The Fed’s Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

[W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

This post has been republished from Mark Thoma's blog, Economist's View.

Why Deflation Is More Likely Than Inflation

While many fear the possibility of inflation, Alan S. Blinder, Princeton professor and former economic adviser to President Clinton, explains why he is not worried about inflation. He argues that deflation is currently a greater danger. To learn why see the following from Economist's View.

Alan Blinder isn't worried about inflation:

Why Inflation Isn’t the Danger, by Alan S. Blinder, Economic View, NY Times: Some people with hypersensitive sniffers say the whiff of future inflation is in the air. ... Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.

First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. ... Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.

Ben S. Bernanke ... and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit. ... But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. ... Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:

• The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.

• The Fed is well aware of the exit problem. It is planning for it... It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

• The Fed will start the exit process when the economy is still below full employment and inflation is below target. So some modest rise in inflation will be welcome. The Fed won’t have to clamp down hard.

...But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.

My conclusion? The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.

This post can also be read at Economist's View.

Why Hyperinflation Is Unlikely

While there have been concerns about hyperinflation of late, there hasn't been much evidence of actual inflation. Tim Iacono from The Mess That Greenspan Made argues that we will probably never see an annual double-digit inflation rate. See the following article to find out why.

Some looked at the inflation statistics released by the Labor Department earlier today and said, "See? Deflation is here!"

Others looked at the same set of price data and replied, "See? Inflation is stirring".

They can't both be right, but they can both be wrong (or at least early).

The annual rate of inflation, measured against the price level of May 2008 (back when gasoline and other commodity prices were soaring), came in at less than minus one percent causing deflationists around the world to rejoice, yet stop short of getting out the bubbly.

Why?

Because, so far, this deflation is the Japanese variety, a wimpy version of the much more serious double-digit deflation as seen in the 1930s which, unfortunately, most deflationists fail to understand is no longer within the realm of the possible, unless of course we go back to something like a gold standard instead of printing up new money by the trillions of dollars to replace the dollars that are being vaporized in the ongoing waves of credit destruction.

Then again, since the Consumer Price Index has been effectively neutered by a 25 percent weighting of owners equivalent rent that, while purportedly representing homeownership costs, instead serves to dampen reported inflation. No matter what home prices or mortgage payments do, owners equivalent rent always seems to rise at an annual rate of two percent (even when home prices are falling by ten times that amount) serving as an anchor on the government inflation data.

Due to owners' equivalent rent, the U.S. may never see another double-digit annual rate of inflation - positive or negative.

These days, as far as government reported inflation is concerned, it's all about energy prices and, there, those seeing deflation have something to look at.



Most of the year-over-year change in the overall consumer price index is either directly or indirectly related to the energy price peak last summer and comparisons to it, serving to distort whatever meaning the price index still contains.

But, the intriguing aspect of this morning's report on consumer prices is that you can see in-flation in the data too. After all, gasoline prices have soared more than 70 percent from about six months ago demonstrating the very real difference between $35 a barrel oil and the much more dear $70 type.

Inflationists (and the much more rabid "hyper-inflationists") look at this recent rise in energy prices and figure it to be a sure sign of things to come, what with all the government money printing that has occurred lately - a lot of the newly printed money seems to be going into the black goo.



Anything that doubles in price over a six month period should grab your attention and, whether or not crude oil prices remain lofty in the months ahead is anything but assured, but it's important to remember that present day oil prices are still more than 200 percent higher than the average of the last few decades.

That was the era of modest inflation that many people naively think we're about to return to.

But, that period was really just a fluke.

Never again will the world have cheap, plentiful oil at the same time that clothes, electronics, and other goods are produced at cut-rate prices in the East, only to be sold in the West, and subsequently included in the West's inflation data.

Those seeing inflation in today's data see a world where prices are very different than they were in the latter years of the 20th century, the late-2008 plunge in prices being just a temporary setback to the inevitable higher prices to come.

In the scheme of things, what happened from early-2008 to early-2009 will probably prove to be quite irrelevant - either a blip that quickly fades from memory or a blip that is eventually dwarfed by other much larger blips.

It's way too early to tell.

However, what is quite easy to discern after the last year or so of price data, is that we've entered a very different world of consumer prices and even owners' equivalent rent may not be able to dampen the effects of the price moves in the years ahead.

We probably won't know for sure until sometime in 2010 whether we'll get debilitating deflation or hyper-inflation, though both remain unlikely, at least in my view.

The current inflation numbers are largely meaningless and anyone who reads too much into them does so at their own peril.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

A Period of Economic Transition

With the prevailing wisdom pointing toward an economic recovery in the near future, the economy is likely entering a transitional period. The longer than average recession will probably mean a longer than usual transitory period. James Picerno from The Capital Spectator discusses what this transitory state could look like.

Flat to a slight upside bias. That about sums up the prevailing state of inflation at the moment, based on this morning's latest from the U.S. Bureau of Labor Statistics.

Seasonally adjusted consumer inflation rose 0.1% last month, up from zero the month before and a modest decrease in March. On its face, that's good news, as it suggests that the risk of deflation, if not quite passed, is looking more and more like a shadow of its formerly threatening self. Meanwhile, inflation as a clear and present danger also remains thin as an imminent menace.

We are in a transitory state, passing from severe danger to something less so. Anything's possible, of course, especially in the current climate. But barring some extraordinary and largely unexpected event, we're likely to press on through what we'll call a pre-recovery period, when the economic numbers improve relative to the recent past yet the numbers don't quite show the traditional bounce that typically accompanies the end of recessions.

"The economy seems to be out of intensive care," says David Shulman, senior economist at UCLA Anderson School of Management. "The freefall stage in dropping output and employment seems to be over, but the economy is still sick."

The prospect of false starts in the data looks quite high in the months ahead. The good news on one day will be reversed by bad news the next, and quite a bit of treading water at other times. The transition state that carries us from recession to growth, in short, will last longer than usual. The evidence will be particularly obvious in the lagging indicators, employment being the most conspicuous example. Indeed, the labor market is still shrinking and will probably continue to do so in the months ahead, perhaps followed by an extended bottoming-out period over several quarters. The economy's capacity to create jobs is likely to come later and be more tepid than has typically been the case following the end of recessions in the post-war era.

Extending the medical metaphor, Bruce Kasman, chief economist for JPMorgan Chase, predicts in BusinessWeek.com yesterday that "the economy will return to growth but not to health."

Last week we wrote of the "technical end" of the recession and our expectation that NBER would eventually get around to declaring the downturn's finish at, well, right about now, give or take a few months. That's good news relative to the recent standard of economic activity. But the technical demise of the recession isn't likely to bring easily recognizable good news on Main Street anytime soon.

As frustrating as that outlook is, it's even more hazardous than is generally recognized. If we're facing an unusually long transition period, there are specific risks linked to this abnormal state of affairs. That includes figuring out how and when to adjust monetary policy to balance two conflicting forces: deflation and inflation. As the former gives way, the latter isn't likely to suddenly pop out and yell "boo." Nonetheless, the future inflation risk isn't trivial, given the massive liquidity that's been created of late and the historical lessons that go with fiat currencies. As we discussed on Monday, the elevated risk this time around will be one of deciding magnitude and timing in adjusting monetary policy going forward. That's always a challenge, although it's likely to be especially problematic in the quarters ahead. Tightening monetary policy too soon may risk choking off a nascent but weak recovery; waiting too long to raise interest rates may give inflation a solid foundation to thrive, an especially troubling thought, given the massive amount of debt incurred over the last 12 months or so.

Overall, economic analysis faces unusually tough times in reading the incoming data and drawing reasonable conclusions about the implications for the future. As a basic example, our proprietary index of economic indicators, published in each issue of The Beta Investment Report, is currently flashing a robust sign of recovery, although this may be misleading because much of the rise has come from monetary policy and, so far, isn't convincingly corroborated in the real economy.

In short, interpreting the economic outlook promises to be quite difficult going forward, much more so than usual. Beware: The risk of false dawns is rising.

This post can also be viewed on capitalspectator.com.

Expectations Of Inflation Rising

Expectations of inflation are on the rise, fueled by the high level of US debt and the weakening dollar. One sign that inflation is on the horizon is that the futures market is predicting that the Federal funds rate will increase to 1.2% by this time next year. For more on this, see the following post by James Picerno from The Capital Spectator.

Arthur Laffer advises in today's Wall Street Journal that it's time to "Get Ready for Inflation and Higher Interest Rates." The market's been telling us no less, as we've been discussing now for some time. Although the deflationary risk has been front and center since the financial crisis erupted last fall, the bigger challenge has always been the next phase, once the Federal Reserve succeeds in driving away the D risk.

One need only review the market's changing forecast of inflation in recent months to recognize that the future isn't likely to look like the past. In charts we've been posting semi-regularly, such as here and here, the trend is clear: pricing power is returning. Yes, it's coming off an extraordinarily low base, which exacerbates the relative comparisons. But there's no question that the central bank has been using extraordinarily potent measures to resuscitate inflation from the grave. As we've been saying all along, we have every confidence that Ben Bernanke and company will be successful.

The market is increasingly of a mind to agree, as indicated by rising interest rates this spring in government bonds. The benchmark 10-year Treasury, for instance, now yields 3.86%, as of last night—161 basis points above 2008's close, according to data from the U.S. Treasury.

Meanwhile, the futures market is predicting that by this time next year, Fed funds will be at ~1.2%, up from the current target rate of 0-0.25%, as our chart below shows.



So far, the rise in rates and rate expectations is a good thing, as it suggests that economic equilibrium is returning and the appetite for risk is on the mend. But at some point it's time to start soaking up the massive liquidity that the Fed has created in the past year. Reasonable minds can debate on exactly when to begin and how far to go, but at some point, and perhaps fairly soon, the monetary equivalent of mopping up must commence.

Laffer's skeptical that reversing the liquidity injections will be reversed in a timely manner, if at all. "Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates," he writes.

We're not quite so pessimistic, although the history of central banking certainly offers plenty of reason to remain cautious on expecting that politically tough decisions will come easy. Indeed, one must be cognizant of the incentives that infuse a world of fiat money and mounting deficits and the political path of least resistance. As Milton Friedman once said, "Inflation is the one form of taxation that can be imposed without legislation."

This post can also be viewed on capitalspectator.com.

How Much Gold You Should Own

Ben Bernanke recently warned congress of the consequences of overspending which could include inflation. If you think inflation will accelerate in the future, it may be a good idea to consider gold to offset the affect of inflation on your investments. For more on this, read the following article by Dr. Steve Sjuggerud from Daily Wealth.

You often hear "You need to own gold!" But how much is the right amount?

You don't want to own too little gold and have the purchasing power of all your savings shrink dramatically. You can't afford that. But you don't want to be an end-of-the-world nutcase either.

Well, one of the world's shrewdest investors – Jean-Marie Eveillard – has 10% to 12% of his extremely successful investment fund allocated to gold and gold plays...

Jean-Marie Eveillard's First Eagle Global Fund beat the stock market every year this decade. What's more, he's done it conservatively... He doesn't take big risks. Over 30 years, he's proven to be one of the most successful mutual fund managers ever.

So what's Jean-Marie Eveillard recommend buying today?

"After equity markets have gone up 35%-40% or more over the past three months, ideas that are immediately appealing are few," he told Bloomberg news today. But he did have one big idea... gold.

Right now, his fund is about 10% invested "in gold and gold mining securities," he said.

His explanation is simple: "It's insurance to protect against the fact that current policies by the American government and the Fed are potentially wildly inflationary."

Jean-Marie likes gold because he expects the Fed will leave interest rates near zero for a very long time.

The Fed will "stay pat until the politicians give them the green light to raise rates, which will take quite a while. As long as unemployment is very high, politicians will be reluctant to push up short-term rates."

When I got into investing nearly 20 years ago, Jean-Marie was already a legend. After doing my homework, his First Eagle Global Fund was one of the very first investments I ever bought. (Back then, it was called the SoGen fund... it still uses its old symbol, SGENX.)

Jean-Marie started managing the fund in 1979. If you had invested $10,000 in the fund back then, it would be worth roughly $500,000 today. (Heck, I should have kept my money in there!)

His "big idea" now is very simple. Gold pays no interest. And money in the bank pays nearly no interest. You can print money. But you can't print gold. If the Fed keeps interest rates near zero for the foreseeable future, the obvious outcome is that it will take more slips of paper (dollar bills) to buy an ounce of gold.

He believes his clients' money should be about 10% or so allocated to gold and gold investments. What's right for your situation? That's up to you. But if you're substantially under or over the legendary investor's gold allocation, then you ought to consider getting more in line with him...

Dailywealth.com offers a free daily investment newsletter which focuses on contrarian investment opportunities.

Should We Worry About Inflation?

Ben Bernanke was on Capital Hill yesterday warning congress that too much deficit spending could harm the economy while downplaying concerns of inflation. It is Bernanke's job to control inflation, but will he be able to keep inflation low with $2 Trillion in deficit spending this year? James Picerno from The Capital Spectator discusses whether we should worry about inflation now.

Inflation's still not a risk but arguably neither is deflation. We're not quite ready to officially claim that the D risk has been vanquished, but we're close. As it turns out, we're not alone.

The bond market is increasingly inclined to turn the page on the fear that a deflationary spiral may threaten. But if the deflation risk is passing, as it seems to be, the change doesn't mean that inflation is back. There's no switch that turns one off and the other on as cleanly as flicking on a light.

The ebb and flow of the economy is a process, an evolution. What we're seeing now, or so it appears, is a transition from a heightened risk of deflation to the absence of that risk, which isn't to be confused with inflation. At least not yet. There's no law that says inflation must quickly follow deflation. But neither is there any force that prevents one from turning into the other. Much depends on what the central bank does; not today but next month, next year and beyond.

Inflation, when it does bite, tends to creep up on you, slowly, quietly, working its way into the economy virtually unseen. It doesn't suddenly arrive one day with fanfare and press releases. More typically, the crowd wakes up one day and realizes that inflation is back. The good news is that there are usually early warning signs. Interest rates, money supply, commodity prices, and so on. The challenge is figuring out in real time what constitutes a legitimate warning vs. noise.

For the moment, the market's telling us that deflation's a fading hazard. As the chart below shows, the implied inflation rate in the bond market (based on the yield spread between the nominal 10-year and inflation indexed Treasuries) was just under 2% as of last night's close. That's still comfortably below the 2.5% rate that prevailed before the financial system ran amuck starting last September. But it's also up sharply from the near-zero levels of December and January.

That's not necessarily surprising or even troublesome. Fearing the worst last fall, the Fed quickly dropped short rates to near zero. The medicine appears to be working, which is to say that Bernanke and company are engineering higher prices. But it's the momentum we fear. Not necessarily today, but down the road.



Some commentators say that all the talk of inflation is premature and perhaps misguided. In his column last week in The New York Times, Paul Krugman advises readers that "when it comes to inflation, the only thing we have to fear is inflation fear itself."

That's a reassuring thought, but unfortunately it runs contrary to the historical record. Maybe this time is different, but we don't know. But the past is certainly clear. Except for a few extraordinary examples to the contrary, inflation has been the norm. For the most part, it's been manageable, although sometimes it spins out of control, as it did in the 1970s and early 1980s. Recessions, of course, have a habit of pounding inflation back into the ground. Even after the current downturn ends, its after-effects are likely to put a lid on pricing pressures and so there's reason to be sanguine about future inflation threats.

The ever-trenchant Martin Wolf advises in his FT column today that there's no economic basis to fear inflation, at least not now. "The jump in bond rates is a desirable normalization after a panic," he writes. "Investors rushed into the dollar and government bonds. Now they are rushing out again."

The question, of course, is when is it safe to start worrying about inflation? The implied inflation rate for the next 10 years is roughly 2%. That's low by historical standards and if it stayed there for the next generation the central bank could claim a well-deserved victory in maintaining price stability, at least by the standards of the 20th century.

But no one knows if inflation will rise to, say, 2% and stay there or keep climbing. Again, much depends on what the central banks do from here on out. One can make an economic case that exploding government debt and massive liquidity injections aren't destined to raise inflation pressures, as Wolf and others explain. That's a reasonable view, but if you're charged with protecting assets, such claims that all's well aren't entirely persuasive.

The bond market, along with the gold and forex markets, are discounting the future and all its risks and they're telling us that the risk of higher inflation is on the march. It's quite possible that the markets are wrong and so inflation will remain a shadow of its former self. Let's hope so. But there's no way of knowing for sure. Strategic-minded investors should hedge their bets. Inflation may remain benign, but it may not. The markets are struggling to put a price on this uncertainty.

In any case, it's the trend rather than the absolute levels that worry investors. Estimating the true rate of inflation is always a contentious subject. But while we can all argue over the numbers, the trend is less obscure, and it's the trend that has some of us worried. Taking out a bit of insurance, then, seems reasonable. Should we bet that house on higher inflation? Of course not. But neither should we discount it entirely. It may be different this time, but 300 years of central banking keeps us wary on buying into yet another argument that a new era has arrived.

This post can also be viewed on capitalspectator.com.

Should Historic Deflation In Britain Be A Concern?

Could deflation be the next big road block on the road to economic recovery? News out of Britain indicates that significant deflation has hit Britain's economy which can lead to things getting worse rather than better. What does the lowest Retail Price Index since they started keeping records mean for Britain's economy? Tim Iacono from the blog The Mess That Greenspan Made, shares his view on the significance of record deflation in Britain.

The British have succumbed to the scourge of deflation and about all the rest of the world can do now is bid them a fond farewell - they've entered the abyss, as reported by the Telegraph.

Britain sinks into deepest deflation since 1948
The British economy sank deeper into deflation last month to the lowest level in more than 60 years as the effect of falling house prices and lower mortgage repayments escalated.

Inflation on the Retail Prices Index (RPI) measure, which includes housing costs, dropped sharply to -1.2pc in the year to April, from -0.4pc in March, the Office for National Statistics (ONS) said on Tuesday.

It was the lowest RPI figure since records began in 1948, and weaker than economists had expected.

The number of times that economists have been taken by surprise over the last few years has been increasing at such an astonishing rate that, sometimes, you have to stop and wonder why we even keep them around.

Maybe we'd be better off with no forecasts and no expectations for the future at all.

More importantly, you have to wonder why their counsel continues to be sought in order to remedy the ills that took them by such great surprise.

Anyway, on the subject of de-flation, the British method of measuring the changes to consumer prices appears to be even more dysfunctional than the one used in the U.S. as central bank lending rates have a direct impact on their broadest measure of inflation which happens to include interest paid via mortgage payments.

So, all other things being equal, if interest rates are slashed, inflation goes down, whereas, if the bank hikes lending rates, inflation goes up.

The main driver of the fall was lower mortgage interest payments following the Bank of England's decision to cut interest rates by half a percentage point to 0.5pc in March, the ONS said.
...
Although in the short term falling prices will appeal to consumers, RPI is used to calculate wage increases so the sharp fall in April is likely to add to downward pressure on salaries already caused by higher unemployment and falling corporate profits.
"As a result, many workers are likely to get wage freezes or even pay cuts," said Howard Archer, chief UK economist at IHS Global Insight.

Deflation poses a further threat to the economy if people expect prices to fall further and put purchasing plans on hold which can, if the trend persists, lead to lower output and even more job losses.

There's the real evil of inflation - right there in that last paragraph...

If people see negative numbers showing up in the government's measure of inflation, they'll stop obsessing about the ongoing financial market meltdown and how it must ultimately lead to the end of life as we've known it and promptly cut back on their already sharply curtailed spending plans in hopes of getting a better deal sometime in the months ahead.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

So What Is The Fed's Next Move?

With the growing number of positive economic reports coming out, many people are questioning whether the economy has turned a corner. Have we really turned a corner, though, or are we seeing a temporary upswing? The Federal Reserve is playing a difficult game right now. If they leave rates low too long we could be faced with inflation, but if they raise them too quickly it could hamper the recovery. With this in mind, the Fed has some challenging decisions ahead of them. How are they going to respond? Mark Thoma looks at a recent article from Tim Duy that addresses this in his blog post below.

Turning Which Corner, by Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

The sharp deceleration has come to an end, of that there can be little doubt. Nor should there be much surprise. The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months. The stabilization in consumer demand will eventually slow the pace of job cuts. Indeed, this is already evident in the data - analysts have pointed topeak of initial claims as a key hurdle in the race to recovery. To be sure, it is difficult if not impossible to characterize the data flow as "good." But it is certainly less "bad." The path to Great Depression II has hit something of a speedbump. And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher.

There will be more opportunities for euphoria - do not underestimate the power of pent-up demand to trigger bursts of positive data. There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation. Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example). I believe, however, that those bursts of data will not be sustainable. Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering .

I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:

The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage." Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend. Countless business plans are based on the expectation that this trend will continue. The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc. Those plans will be stressed, to say the least, if the trend stalls. The implications for a reversal are even more significant. And for those that believe reversal is necessary, note that the reversal has really not even begun. What took 25 years to build may take another 25 years to destroy.

How sure are we that the trend is at an end? My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end. Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation). And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate.

The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on investment and external spending. This, however, is easier said then done. How quickly can 25 years of growth directed at consumer spending be reversed? And reversed to what, especially if the rest of the world continues to struggle? I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity. Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if the savings proclivities of households continue to exceed the investment intentions of firms.

Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity. Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers. Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers. In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation. In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream.

What is the Fed's next move? One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November. Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data. Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment. Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting. More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003:

The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero.
From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%:

“I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope.”

“It’s extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness."

A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets. And comparatively, financial markets were leaps and bounds healthier in 2003 than now. Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess? Moreover, consider the disinflation worries in 2003 and fast forward to last week:

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

Now consider the output gap over the last decade:

The current gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually. As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing. The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases. Given Bernanke's past behavior, expecting patience on his part seems unrealistic. Moreover, the last jobs report provides less room for optimism than observers suggest. Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory.

Bottom Line: The economy looks to be turning a corner relative to the downward cyclical force of last year. But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data. In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing. Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges).

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