What Is The Correlation Between Oil Prices And Inflation?

Many investors believe that the movement in oil prices can give them advance signals into how inflation will change in the future. Is there any truth to this, though? Well, Mehmet Pasaogullari and Patricia Waiwood from the Federal Reserve of Cleveland recently ran the numbers to help answer that question once and for all. Here is the summary of their findings, which you can read more about here:

Some analysts pay particular attention to oil prices, thinking they might give an advance signal of changes in inflation. However, using a variety of statistical tests, we find that adding oil prices does little to improve forecasts of CPI inflation. Our results suggest that higher oil prices today do not necessarily signal higher CPI inflation next year, although they do help to explain short-term movements in the CPI.

Being able to predict changes in inflation could make investors a lot of money, but apparently using oil prices to foretell those changes isn't the golden goose some people thought.

Inflation May Help Economy, Expert Says

At least one economist argues that allowing inflation to occur “naturally” could actually help the struggling U.S. economy. Mark Thoma notes the Federal Reserve is expected to implement controls if inflation approaches 2% and unemployment remains high by raising interest rates in an effort to retain “inflation credibility,” rather than keeping them low through 2014 as it had previously announced it would do. Thoma argues, however, that exerting control to hit a particular inflation target absent consideration of the other factors is unwise, and that inflation during a recession can encourage more activity in the market rather than restrain it. For more on this continue reading the following article from Economist’s View. 

If inflation begins to increase before the economy has fully recovered, the Fed shouldn't panic:

Federal Reserve Policy: Exceptions Improve the Rule: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2% target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?

Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2% target even if the economy has not yet fully recovered.

As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility? ...[continue reading]...

 This blog post was republished with permission from Economist's View.

Stocks Up, Consumer Sentiment Down

Rising gas prices are having a negative impact on U.S. consumer sentiment, although projections suggest the feeling is temporary according to the Reuters/University of Michigan consumer sentiment index. The Energy Department noted prices edged up another $0.04 in the past week, keeping more money in the pump and leaving consumers with less to spend elsewhere. Meanwhile, improvements in the stock market have some wondering about inflation, including Federal Reserve chairman Ben Bernanke, despite gains being propped up by a strengthening labor market. For more on this continue reading the following article from Tim Iacono.

The Reuters/University of Michigan consumer sentiment index dipped from 75.3 in February to 74.3 in the first of two readings for March in a sign that rising gas prices may now be having in an impact on the mood of the consumer.

Based in large part on a recently improving labor market, the current conditions component remains firm, up from 83.0 to 84.2, however, the expectations component more than offset that gain, down from 70.3 to 68.0.

It’s a good think that equity markets don’t have a gas tank to fill every week or they too might think about pulling back but, so far, they show little sign of doing so, though that could soon change given that inflation expectations show signs of stirring to life.

Survey respondents ratcheted up their one-year outlook on consumer prices from an increase of 3.3 percent to 4.0 percent in a delayed reaction to rising pump prices that the Energy Department said gained another 4 cents over the last week, rising to a national average of $3.83 per gallon.

Five-year inflation expectations (the measure watched more closely by Fed economists) rose just one-tenth to 3.0 percent, indicating that, like Fed Chief Ben Bernanke, most Americans see rising gas prices as being temporary, a belief that, unlike Bernanke’s, could prove to be temporary itself.

This blog post was republished with permission from Tim Iacono.

US Inflation Up, Prices Increasing

The U.S. Department of Labor reports a 3.9% annual increase in inflation when including food and energy, with gasoline up 33.2% on the year and food 4.5% more expensive. Clothing costs are also on the rise, despite remaining lower than prices reported two decades ago thanks to inexpensive imports, leaving consumers to deal with price increases in three key purchase areas. Observers note inflation is now at its highest since September 2008, although the central bank reports inflation controls are in place and working. For more on this continue reading the following article from Tim Iacono.

The Labor Department reported that the rising cost of energy products and food drove consumer prices 0.3 percent higher in September and that the annual inflation rate now stands at 3.9 percent, the highest level since September 2008.

Paced by a 2.9 percent rise for gasoline, up 33.2 percent on a year-over-year basis, overall energy prices jumped 2.0 percent last month and are now up 19.3 percent from a year ago.

Food & beverage prices rose 0.4 percent in September and are now 4.5 percent higher than last year at this time while the “food at home” subcategory rose 0.6 percent for the third month in a row, now up a stunning 6.3 percent on a year-over-year basis.

Elsewhere, price increases were more moderate and clothing prices reversed their recent trend by dipping 1.1 percent last month, however, apparel prices are still 3.5 percent higher than a year ago, down from the August year-over-year rate of 4.2 percent that marked a 20-year high.

Amazingly, up until this summer, apparel prices had been 10 percent or more below the highs seen in the mid-1990s, this 15-year trend due largely to the rise in inexpensive imports. However, from April to August of this year, apparel prices have surged more than five percent, cutting this gap almost in half.

Here’s a long-term chart showing this recent dramatic increase:

Americans can now add clothing to two other categories where prices have been rising sharply lately – food and energy – as these indispensable items put more pressure on consumers despite assurances from the central bank that inflation is under control.

This blog post was republished with permission from Tim Iacono.

Commodity Price Shock Impacting Retail Margins

Large retail manufacturers like Newell Rubbermaid, Inc. – maker of storage containers, Sharpie pens, cookware and other items – are struggling with increased costs for raw materials, and some decided to pass those cost onto consumers. Now, as second-quarter profit margins are not being met, directors are wondering whether that was the best way to make up the difference caused by increased commodity costs. The pain is reflected in many retail stores, including even in the discount market, that are seeing sales drop as consumers choose to forgo purchasing typically economically-priced items rather than absorb the higher costs. For more on this continue reading the following article from The Economist's View.

One more from Tim Duy:

Consumer Update, by Tim Duy: I noticed this in the Wall Street Journal:

Newell Rubbermaid Inc.'s second-quarter earnings rose 13%, helped by fewer restructuring charges, but margins fell as the household-products company's price increases couldn't fully offset rising commodity costs.

It reminded me of this from the Beige Book:

For the most part, firms' ability to pass on price increases remained mixed.

And those attempts to push through price increases where when the economy was "good." Imagine now. Those worried about runaway inflation vastly underestimate consumer's ability to absorb higher prices. Back to the Wall Street Journal:

Newell—whose lineup includes storage products, Sharpie pens and Calphalon cookware—warned last month that several of its large retail customers in the U.S. were beginning to reduce orders, pointing to weak consumer confidence. The Atlanta-based company's earnings have improved in recent quarters, though revenue fell in the first quarter, primarily because of fewer promotions and consumer purchases of less expensive products. Newell, like other consumer-product manufacturers, is also raising prices and trying to reduce spending in an effort to mitigate rising raw-materials costs.

Not surprising - spend less money on marketing while raising prices in a weak environment and sales growth struggles. Consumers can't absorb it as they can in a real wage-price spiral; instead they just downgrade or go without. Also note the role consumer confidence number are playing. Perhaps just a self- inflicted wound that will pass with the new debt deal?

Regarding the consumer, I don't know how many people caught this two weeks ago, also from the Wall Street Journal:

Sales and profit growth have started to slump at the deep-discount retailers called dollar stores, after a robust performance during the recession, a sign that even fairly cheap toys and other small indulgences now are a stretch for some consumers.

In the past several weeks, Dollar General Corp. and Family Dollar Stores Inc., the country's largest chains that sell sharply discounted food, household staples and other items in modest-size stores, missed their quarterly earnings targets. The two chains, as well as Dollar Tree Inc., also reported gross profit-margin declines.

Note the title of this story - "splurges" at dollar store's are drying up! At the dollar store! And note the price sensitivity:

"We have 228 items that are priced at $1 that we think are incredibly important to our customers that we elected not to take price increases on," Dollar General Chief Executive Rick Dreiling told analysts during a June 1 earnings conference call. "This sounds almost silly, but a $1 item going to $1.15 in our channel is a major change for our customer."

Fifteen cents or fifteen percent? It all depends on your perspective. But I think the bottom line is that the commodity price shock severely impacted consumers. Some corporate leaders thought they saw an opportunity to raise prices, and are now paying the price. And one wonders how many were driven to raise prices by the recent six month surge of warnings that runaway inflation is close at hand?

This blog post was republished with permission from The Economist's View.

Trusting the Fed on Inflation? Apparently.

In a press conference on Wednesday, Federal Reserve Chief Ben Bernanke attempted to convince consumers that inflation in the long-term won't be an issue. Read more about this in the full post by The Mess That Greenspan Made.

The Federal Reserve seems to have those they think matter most – consumers responding to surveys and the bond market – convinced that inflation over the long-term is not going to be a problem, one of the key points made by Fed Chief Ben Bernanke in Wednesday’s press conference. This report in the Wall Street Journal today takes up that issue and presents the key measures that economists at the central bank watch closely.

Long-term inflation-expectations, from consumers and from the bond market, remain subdued and are little changed from a year ago. They point to inflation that isn’t far above the average of the past decade, when inflation was historically low.

One rough gauge of future inflation expectations is the gap between yields on plain-vanilla Treasury bonds and Treasury inflation-protected securities of the same maturity.

One favorite such measure is the “five-year, five-year-forward” break-even rate, which measures inflation expectations starting five years from now and running five years from that date.

The Federal Reserve Bank of New York’s five year, five-year forward break-even rate estimate, widely acknowledged as the gold standard of such rates, was recently 3.02%, slightly below its level in November, when the Fed announced its $600 billion quantitative easing program, or QE2.
…
A measure of long-term consumer inflation expectations echoes the message of the TIPS market. According to a monthly survey by the University of Michigan, consumers expect CPI inflation of just 2.9% in the next five years, according to a preliminary survey in April.

That long-term calm is in stark contrast to consumers’ short-term view, which sees inflation jumping 4.6% in the next year, the highest since August 2008, when oil prices were just off their highs near $150 a barrel.

Let’s hope that the Bernanke Fed is better at predicting the future path of consumer prices than they were at seeing into the future a few years ago and forecasting where home price might go and how credit markets and the banking system would hold up.

This blog post was republished with permission from The Mess That Greenspan Made.

What's Up With Inflation?

Most people have probably noticed by now that prices have been rising of late for many of the goods and services they purchase. Wondering what the latest U.S. inflation rate is? Well this Thursday we will find out - just keep in mind that the government's report isn't always the most accurate measure of "real" inflation. Tim Iacono talks more about this, as well as the most recent inflation reports released by China and the U.K., in his blog post below.

The latest reading on consumer prices in the U.S. will be released on Thursday and there have already been rumblings about the Labor Department printing a surprisingly big number after last month’s 1.5 percent increase, the biggest jump in government reported consumer prices (which may vary considerably from your personal experience) in 19 months.

If there’s one thing that the U.S. government’s economists and bean counters have become quite adept at over the years, it is ensuring that inflation doesn’t come in too hot, so, don’t get your hopes up for too big of an upside surprise.

In China, the latest data showed consumer prices rising at a 4.9 percent year-over-year rate, down from the 5+ percent rate of a month or two ago but still causing problems amongst the population since food prices are rising at more than double the overall rate.

[Hmm... Here's an interesting one from Google - if you search on "China Inflation" on Google News, atop the list you get stories about gold in China rather than inflation in China.]

Anyway, Reuters reports that ex-food inflation is now a big concern in the Middle Kingdom:

Chinese inflation hit a lower-than-forecast 4.9 percent in January, but price pressures excluding food were their strongest in at least a decade and will force the central bank to keep tightening monetary policy.

In a tentative sign that its actions so far, including higher interest rates and lending restrictions, have started to bite, money growth eased to its slowest pace in six months in January at 17.2 percent year on year.

Now, I don’t know about you, but whenever I hear something like money supply growth “easing” to 17.2 percent, it reminds me that some parts of the world’s financial media (along with most of its economists) have gone completely mad.

Yes, future historians will one day look back and laugh at the naive belief of our era that, somehow, money supply growing at three or four times the rate of government reported inflation was somehow sustainable.

In the U.K., they continue to have a little inflation problem too and, as the Bank of England has been saying for a few years now, higher prices are just a temporary development. The Telegraph reports that BOE Chief Mervyn King had to write another letter to the Chancellor this month to explain why:

Mr King continued to blame the over-target inflation on “temporary effects”, citing the increase in VAT to 20pc at the start of the month, the fall in the pound and soaring commodity prices.
…
Mr King made the comments in his latest letter to the Chancellor after the Office for National Statistics (ONS) reported that higher oil prices and the recent VAT rise drove CPI inflation from 3.7pc in December to its highest point in more than two years.

Importantly, a broader measure of inflation in the U.K. that includes some of the costs of homeownership is now at just over 5 percent.

What will U.S. inflation look like on Thursday?

Despite soaring gasoline prices (I should know, we just got back from California) and with nearly every other measure of prices in the U.S. coming in at some multiple of the official rate of inflation, you’d think that eventually we’d see some of this show up in the government’s consumer price data, particularly since you read reports daily about manufacturers finally passing their rising input costs along to consumers.

Maybe Thursday will be the day.

This post was republished with permission from The Mess That Greenspan Made.

The Growing Inflation Battle

Inflation is growing in many emerging markets, and a battle is brewing between the US and these countries. The US doesn't seem willing to budge on its current economic path, while the emerging markets are reluctant to allow their currencies to appreciate. Economics Professor, Mark Thoma, takes a closer look at this battle in his blog post below.

Tim Duy notes rising concern about inflation from hawkish central bankers in Europe and elsewhere, and the tension that is building "as emerging markets fight the Fed":

Inevitable Inflation Fears, by Tim Duy: The Wall Street Journal is reporting that ECB head Jean-Claude Trichet is turning increasingly hawkish:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.

In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy…

An interesting development in light of the ongoing (or is it never ending?) European Debt Crisis. Rate hikes will just be adding insult to injury for the peripheral nations already struggling with a debt-deflation spiral. The price for being part of the Euro just keeps getting higher.

Inflation fears have yet to grip the Federal Reserve, for good reason. Back to the Wall Street Journal:

While high unemployment and spare capacity are restraining underlying inflation pressures in the U.S. and elsewhere in the developed world, annual inflation in China is almost 5%—and a sizzling 9.8% economic growth rate in the fourth quarter triggered fears of more price pressures ahead. Inflation in Brazil is even higher.

The next inflation crisis is not occurring in the US, as opponents of QE2 thought likely, but in the developing markets instead. To be sure, my sympathy for developing nations wore thin long ago. They will identify the Federal Reserve as the proximate cause of their problems, whereas they have only themselves to blame. Higher inflation abroad was the only outcome if the protocols of Bretton Woods II did not submit to the onslaught of QE2. And the Federal Reserve has very good reason to keep the pedal to the medal. A review of recent inflation behavior:



If inflation abroad is a problem, it is not because the Federal Reserve has set rates too low, but because emerging markets been unwilling to allow their currencies to appreciate sufficiently against the Dollar. See, for example, recent Dollar buying on the part of Brazil. See also Paul Krugman, who illustrates the clear difference in emerging and developed nation industrial production trends. Again, if inflation abroad is a problem, it is one that emerging markets need to tackle themselves.

Expect global tensions to continue building as emerging markets fight the Fed. While the Fed may identify higher commodity prices as a potential concern, policymakers are not likely to reverse course and tighten policy unless higher commodity prices push through to core inflation. Such an outcome appears unlikely given persistently high unemployment. Consider too that the likely outcome of rising commodity prices is to slow US growth, thereby decreasing the odds of pass-through to core.

I have said this before – I do not see how this ends well. Given that the Fed is not likely to back down from this fight, emerging markets need to put the brakes on their internal inflation issues, the sooner the better. Otherwise they will be facing pain of a real inflation crisis, one that requires stepping on the brakes even harder. How this story unfolds this year will determine of the global economy can transition to a sustainable, balanced growth trajectory, or plunges into yet another of the seemingly all-too-frequent crises.

This post was republished with permission from The Economist's View Blog.

Market's Inflation Outlook Increased Half A Percent Since August

The market's inflation outlook climbed to 1.95%, up nearly half a percent since August, providing a good indication that deflation risk is fading. Additionally, money supply is no longer contracting and commodity prices have been rising. See the following post from The Capital Spectator.

The Treasury market's inflation expectations have bounced higher since the end of August, reversing the summer downturn that was driven by worries that deflationary pressures were on the march. Given the precarious nature of the economic rebound, it's premature to declare the deflationary scare over. But the evidence is certainly looking stronger (or less discouraging) for arguing that the Federal Reserve is ahead of the curve these days rather than behind it.



Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries, a proxy for the market's inflation outlook. It's imperfect and subject to error, of course, just like every other metric that's used to forecast the unknowable future. But as a measure of market sentiment, it's worth watching. As of yesterday, this spread was 1.95%, up from around 1.5% in late August, as the chart below shows. Is that the all-clear sign? No, but it's obviously a move in the right direction.



The bounce in the Treasury market's inflation forecast is strengthened by the fact that commodities prices have been rising lately too. As one example, consider the recent increase in the iPath Dow Jones-UBS Commodity ETN (DJP), a broad measure of futures prices for raw materials. Since the end of August, this exchange-traded fund is up more than 10%. No sign of deflation here.

Another sign that the crowd thinks that the risk of deflation has been retreating recently: higher stock prices. The S&P 500 has been climbing almost non-stop since early September, returning to levels previously reached in May. That's a significant rebound because May was the month when deflation worries emerged anew and prices started to tumble.



Another reason for downgrading deflation fears a notch: money supply is no longer contracting on an annual basis. Weekly readings of seasonally adjusted MZM money stock, for instance, rose slightly on a year-over-year basis for much of September. That's still close enough to zero to wonder what the future holds, but the outright contraction in the annual change from the summer is clearly history, at least for now.

In fact, the central bank is reportedly set to expand its war on deflationary anxiety by formally raising its target rate for inflation. As Bloomberg News reports today:

Federal Reserve policy makers may want Americans to expect inflation to accelerate in the future so they spend more of their money now.

Central bankers, seeking ways to boost flagging growth after lowering interest rates almost to zero and buying $1.7 trillion of securities, are weighing strategies for raising inflation expectations as well as expanding the balance sheet by purchasing Treasuries, according to minutes of the Fed’s Sept. 21 meeting released yesterday.

Some Fed officials are concerned that expectations of lower inflation will become self-fulfilling, damping demand by increasing borrowing costs in real terms, the minutes said. By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy. Chairman Ben S. Bernanke said in 2003 that Japan could beat deflation by using a “publicly announced, gradually rising price-level target.”

“The Fed is on the verge of actively targeting a higher inflation rate,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. U.S. stocks advanced, sending benchmark indexes to five-month highs, the dollar fell and gold declined for the first time in three days after the minutes were released.

Clearly, expectations that the Fed can and will do more to stimulate the economy—despite the fact that nominal interest rates are virtually zero—has changed the sentiment lately. For the moment, the idea that the central bank is out of bullets at the zero bound is on the defensive. Is quantitative easing (QE), in all its various forms, a silver bullet? No, but it can help, and perhaps more than the critics acknowledge. Yet there's also a danger of assuming too much. Still, QE isn't chopped liver, or so recent market actions suggest. In any case, the Fed seems inclined to continue with QE for the near term, as implied in yesterday's release of the minutes for the Sep. 21 FOMC meeting. Reviewing last month's discussions among the monetary mavens inspires expectations that the Fed will announce a new semi-bold round of QE at the next FOMC meeting on Nov. 2-3.

The true test, of course, is whether the Fed's ability to move market sentiment, on the margins or otherwise, will translate into real change in the economy, i.e., enhance job creation. Given the normal lag in the employment picture, definitive answers are going to take time. Meanwhile, the connection between QE and the labor market is an open debate, and one that elicits a fair amount of skepticism, and rightly so. Attempting to fend off deflation with monetary policy is one thing; creating jobs with QE is another. But for the moment, there's a bit more optimism that Bernanke and company can at least make a change for the better on the margins. The Great Experiment rolls on.

As always, there are risks, however. There are no free lunches in monetary economics. Many strategists (and some Fed members) warn that elevating inflation expectations is a dangerous game if—if—the Fed loses control of the momentum. In a world awash in debt and deficits, higher inflation comes prepackaged with some obvious hazards down the road. But at the moment, the debt and deficits are still creating a bias toward deflation, or at least disinflation. Arguably, the only reason we don't have outright deflation is that the central bank has kept the beast at bay.

Rest assured, at some point the inflationary threat will return...eventually. In the long run, the main challenge is navigating the transition from fighting deflation to keeping a lid on higher inflation. But not yet. Soon, perhaps sooner than we think, but not yet. The real problem is that deciding when the deflation risk is truly dead is as much art as it is science, perhaps more of the former. Monetary policy has come a long way since the errors of the Great Depression, but subjectivity is still alive and kicking.

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

Inflation Appears To Be Heading Higher

Inflation expectations appear to be rising as the Federal Reserve is being more aggressive than it was in the summer. The dollar is in decline and heading toward its lowest point for the year, and the the reflation trade is in full swing. See the following post from The Capital Spectator.

The IMF's new forecast for the world economy calls for 4.8% growth for all of 2010, or slightly higher from the July prediction. The outlook for the U.S. economy, however, was revised down for this year: 2.6% vs. the summer forecast of 3.3%.

“The world economic recovery is proceeding,” IMF Chief Economist Olivier Blanchard explained in a press conference. “But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries.”

Same old, same old. But the difference now is that the Federal Reserve is mounting a stronger monetary response than it was during the summer. In essence, the central bank is trying to juice the economy by raising inflation expectations and thereby boost nominal GDP growth. Will it work? We'll find out soon enough, but this much is clear: various corners of the market are inclined to see inflation rising. It's only a marginal change from recent history, but it seems to building a head of steam. The first half of the strategy seems to be working. It's the second half that's the key, though, but figuring out if that's coming as well will take time.

Meanwhile, it looks like inflation expectations are on the rise. Exhibit A is the price of gold, which continues to run higher and is closing in on $1360/oz. Higher gold prices generally translate into a weaker dollar, and this time is no exception. The U.S. Dollar Index continues to weaken and is nearing its low point for the year. Unsurprisingly, the whiff of higher inflation has also elevated commodity prices generally. The S&P GSCI Index, for instance, is now trading at its highest level this year, due in no small part to the rising price of oil.

Of course, the bond market is responding too. The inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, inched up again yesterday, settling at 1.89%, the highest since June.



What's extraordinary about the market's rising inflation outlook is that it's accompanied, at least for the moment, by a falling yield on the benchmark 10-year Treasury, which fell to 2.41% yesterday, based on Treasury data. That's the lowest since the depths of the 2008 financial crisis, when the 10-year yield hovered just above 2.0% at one point.

In short, the final act in the great reflation trade is in full swing. But if you're expecting a consensus among economists on whether this works, or not, you're expecting too much. Scott Sumner, for example, has been arguing for some time that monetary policy still has traction. Not everyone agrees. In fact, some dismal scientists see nothing but trouble ahead. Joseph Stiglitz estimates the odds of success for additional monetary stimulus at the zero bound is, well, zero, he writes.

From the Great Moderation to the Great Recession to the Great Reflation and now the Great Experiment in a few short years. Macroeconomics may be headed for a major rewrite (or not?). Details to follow.

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

The Fed May Introduce A $1 Trillion Treasury Purchase Program

Jeff Kleintop writes in The Street that The Federal Reserve has indicated that inflation is too low which suggests that it will likely take action to reflate the economy. In order to prevent deflation the Fed would likely pursue a strategy to increase the money supply and may introduce a $1 trillion Treasury purchase program at its next meeting, on Nov. 3. See the following article from The Street.

Last week, the official recession-dating committee, the National Bureau of Economic Research, announced that the recession was officially over in June of 2009. This was not surprising to most market participants.

In fact, the LPL Financial Current Conditions Index reflected at that time a move from contraction to growth. However, the question today that most investors want to see addressed is: Will the economy slip back into recession? On that note, the Federal Reserve's message last week implied the Fed was preparing to take action to help ensure the economy avoids a return to recession.

In a surprisingly transparent statement made last week, the Fed told us that inflation is so low it is not doing enough to promote growth. Specifically, the Fed's stated: "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."

The Fed balances employment and prices by seeking growth that generates the highest level of employment without causing too much price inflation. The Fed has spent much of the past 30 years determining when to attempt to slow down an economy that is growing too rapidly in order to avoid the destructive effects of high inflation. However, when inflation gets too low, as the Fed has noted, it is a sign that growth needs a boost.

The Fed typically acts as a counterweight to Congress' inflationary spending impulses. But the Fed has communicated its view that inflation is too low. With Congress unlikely to pass another substantial spending package, the Fed is likely to take action.

Deflation Defined

If inflation is a bad thing, then how can inflation be too low?

Inflation results when too much money is chasing too few goods and services. This results in higher prices and usually happens when demand is strong but output is constrained in the form of shortages of materials or capacity. Deflation, or falling prices, is the opposite of inflation and generally occurs when the supply of goods rises faster than the supply of money.

The problem with deflation is that when prices fall as output exceeds demand it can become self-perpetuating as consumers and businesses postpone spending because they believe prices will fall further. Consumers and businesses delay buying expensive items like homes or cars because they believe these things will be cheaper in the future. As a result, spending and economic growth slows. But it does not stop there.

Businesses profits weaken straining their ability to pay their debts and leading them to cut production and workers. This, in turn, results in lower demand for goods which leads to even lower prices and so on as a destructive downward spiral takes root.

From Deflation to Reflation

To combat fears of a downward spiral of deflation the Fed is preparing a reflation strategy. Typically, the Fed lowers the cost of money, or interest rates, when it wants to promote growth. But with the Fed having already lowered rates effectively to zero, it intends to increase the supply of money by buying bonds in the market.

The Fed will likely be engaging in quantitative easing. That means it will expand the supply of money in the financial system in an effort to encourage lending and economic growth. This can counter deflationary fears by directly inflating the money supply. All else equal, this means that with more dollars in the system, the value of the dollar goes down and prices in dollar terms go up, resulting in a faster pace of inflation.

The Fed took a small step in the direction of providing more stimulus at its Aug. 10 meeting when it committed to increasing the quantity of money in the financial system by purchasing Treasuries as the housing debt the Fed holds matures.

Last week, at its Sept. 21 meeting, the Fed paved the way for another much larger quantitative easing at an upcoming meeting later this year. The Fed may introduce a $1 trillion Treasury purchase program at its next meeting, on Nov. 3.

Investing for Reflation

Incorporating the theme of reflation into your portfolio may be beneficial. Key positive effects of reflation are likely to be seen in precious metals, commodities, commodity-sensitive stocks, emerging markets, real estate and Treasuries. The dollar and the financial sector may be negatively impacted.

Precious metals: Gold may be the most obvious beneficiary of the Fed's intentions. Inflation and a falling dollar tend to lift gold investment demand as a way to preserve value. Gold prices made new all-time highs last week. This trend can continue as the dollar falls and inflation picks up.

Commodities: Commodity prices, including those of cotton, copper, and corn, just to name a few, may also benefit from the outlook for reflation and dollar depreciation. The potency of the reflation theme as it related to commodities can be seen in crude oil. Crude prices were up on the week despite the report of near record-breaking U.S. inventories.

Commodity-sensitive stocks: The Fed's intention to avoid a return to recession and the potential for another liquidity-fueled rally like that of 2009 argue in favor of stock market performance.

On the other hand, the effectiveness of the Fed's actions remains to be seen with liquidity already abundant in the financial system the inflationary consequences seem more assured than better growth prospects. Stocks gained 1% for the week following the Fed's announcement.

However, stocks generally slumped shortly after the Fed's announcement on Tuesday. The gains came on Friday as stronger-than-expected data on business spending were released. Not surprisingly, the commodity-driven Materials and Energy sectors outperformed the S&P 500.

Emerging Markets: If the dollar weakens, gains in investments denominated in foreign currencies translate into more dollars, boosting possible returns. Emerging Market stocks and bonds benefit from appreciating currencies relative to the dollar and the increasing value of their commodity-based output.

High-Yield bonds: High-yield bonds may benefit as yield hungry investors are forced to take on more credit risk to maintain yields.

Real estate: Reflation benefits real estate because property prices may rise. But to really boost Real Estate Investment Trust (REIT) performance, reflation must be successful and generate better U.S. economic growth and employment, which is less assured than the inflation consequences.

Treasuries: Purchasing Treasuries will be the primary way the Fed implements Operation Reflation. The price of the 10-year Treasury note rallied, pushing down the yield 10 basis points since the announcement by the Fed last week.

However, while there may be additional short-term gains for Treasuries, longer-term inflation risks are increasing as well. This risk is evident in the nearly record-breaking spread between 10- and 30-year Treasury bond yields at about 1.2 percentage points.

The better economic data reported in September have pushed prices down and the yield up on the 10-year Treasury by 14 basis points this month while the more inflation-sensitive, longer-term 30-year Treasury yields have increased 28 basis points. Direct beneficiaries of reflation are TIPS, or Treasury Inflation-Protected Securities. The principal of TIPS increases with inflation.



Dollar: The Fed's intentions are weighing on the greenback. As the Fed increases the quantity of dollars in the financial system the value of the dollar is likely to fall. The Fed's statement drove the dollar to its lowest level in nearly eight months. The dollar even strengthened against the euro despite news of deteriorating European economic growth and spiking Irish and Portuguese bond yields on rising default concerns.

Even more impressively, the move in the dollar eroded nearly all of the start of a downtrend in the yen versus the dollar that the Bank of Japan took great efforts to create in the week before the Fed meeting. A falling dollar and rising inflation puts pressure on cash as a long-term holding.

Financial stocks: Bank stocks may be negatively affected by the Fed's intentions. If five- to 10-year Treasury yields move lower on Fed buying, the profit margin banks earn by borrowing short-term and lending longer-term narrows, crimping profits.

On the other hand, investment banks may benefit from the additional credit to fuel profitable merger and acquisition deals and more bond underwriting as businesses look to refinance at lower rates. Nevertheless, since the Fed announcement, financials have been the worst performing sector.

Longer-Term Impact

While the near-term impacts of Operation Reflation are reasonably clear, the longer-term effects are not. Unlike during the financial crisis when liquidity was scarce, the benefits of adding more cash into the financial system on growth and employment may be very limited in the current environment given the already high cash balances at banks and corporations.

In addition, U.S. stimulus cash may wind up fueling emerging market-growth as U.S. companies deploy the cheap cash to fuel growth in markets with lower labor costs and stronger demand. The Fed also risks undermining the lower interest rates that are essential to growth by devaluing the dollar, making U.S. Treasury bonds less attractive to the foreign investors that we are increasingly dependent upon to fund our national debt.

We are cautious on the longer-term economic growth impact of another round of stimulus. However, we do not believe a return to recession is the most likely outcome and believe that the economy will muddle through with below-average growth in the coming quarters.

In the near-term, Operation Reflation provides us with an investment theme. And lastly, though we expect near-term weakness in the stock market, the timing of the mid-term elections on Nov. 2 and the Fed's next meeting on Nov. 3 could help to fuel a year-end rally for stocks.

This article by Jeff Kleintop has been republished from The Street, an investment news and analysis site.

The Surprising Relationship Between Gold And Inflation

The Wall Street Journal points out that the correlation between inflation and gold price movement is extremely small. This suggests that there is a popular misconception that gold in a hedge against inflation. See the following post from Expected Returns.

Regular readers of this blog know my views on gold are unconventional. I've repeatedly said that gold is neither a commodity nor a hedge against inflation. I've instead opined that gold is a hedge against government stupidity and fiscal mismanagement.

Most people believe the conventional wisdom that gold is a hedge against inflation, which is why most people have missed the decade-long bull market in gold. Amazingly, people refuse to amend their errors and continue to call gold "expensive." I, for one, beg to differ- ignorance is expensive.

That being said, the Wall Street Journal finally came out with an article on gold worthy of publication. The article questions conventional wisdom and introduces a radical concept (at least when it comes to the WSJ and gold): analyzing actual data before coming to conclusions! Thinly veiled sarcasm aside, here are some excellent points from the article.

Inflation Hedge?

I recently asked research firm Ibbotson Associates to run a correlation study to determine how closely inflation and gold-price movements track each other. You would expect gold, as a purported commodity, and inflation to move in tandem.

The data, going back to 1978 and capturing an inflationary spike, shows a correlation of, at most, 0.08.

That is low. Really low. Perfect correlation is 1; at minus-1, two assets move in perfect opposition. Near 0 implies gold and inflation barely acknowledge one another, and moves in unison are largely happenstance.

So if inflation doesn't push and pull at gold prices, what might it be? If you believe correlation studies, the answer is the U.S. dollar.

Going back to 1973—a period that defines the modern, non-gold-backed dollar—the greenback's movements closely track gold's direction. The correlation between month-end gold prices and the Major Currencies Dollar Index, as reported by the Federal Reserve, is minus-0.45.

About 1% of the population understands that gold's main role is not to hedge against inflation, but to hedge against the government. Rising gold based on collapsing confidence, and not inflation, is a historical phenomenon. This is a critical point to understand since few would disagree that confidence in government is waning.

Gold as Currency?

...Over the past 30 years, the correlation between the dollar and gold is minus-0.65—a high negative correlation. It means the dollar and gold are effectively on opposite ends of a seesaw. When the dollar is in favor, gold retreats. When it is under pressure, gold prices swell.

Look at the nearby chart. It is like a photo of a mountain scene reflected in a tranquil lake. The rises and falls and horizontal meanderings of gold are nearly the negative of the dollar's.

The implication is that gold isn't a commodity—at least not one that hews to the definition of something that people and industry consume.

Instead, "gold is a currency" whose daily price is a gauge of the market's concern about the "potential diminishment" of the purchasing power of the dollar and other paper currencies, says Paul Brodsky, a principal at New York's QB Asset Management.

I've recently made the point that the big swings in inflation are based on dollar movements. In other words, inflation is not solely an internal phenomenon; it can arise from exogenous shocks in foreign exchange. So a global collapse in fiat currencies will create inflation in America. The bigger the collapse in global confidence, the bigger the inflation. This is why I like to say that inflation is currency-driven.

Those who predict collapsing gold prices are missing the big picture. Collapsing gold prices imply a substantial rise in confidence in government. Let this statement sink in. How anyone can argue for a rise in confidence in government is beyond me.

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

Consumer Price Index Grows At Fastest Pace Since August 2009

A 0.4% increase in retail sales in July offers a bit of optimism that the economy is growing according to James Picerno. Additionally, the fastest pace of growth for the consumer price index since August 2009 suggests a decrease in deflation risk. See the following post from The Capital Spectator.

Retail sales posted a modest gain in July and consumer prices advanced as well, delivering some much-needed statistical counterpoints to the deflation-is-fate argument of late. But closer inspection of the numbers leaves plenty of room for debate about the economic outlook. Beggars, of course, can't be choosy and so the numbers du jour are welcome if not exactly cause for celebration.

Let’s start with consumer prices. The consumer price index (CPI) rose 0.3% on a seasonally adjusted basis last month. That's the highest pace since August 2009’s 0.4%. For the weekend, at least, it's harder to argue that deflation is upon us. The latest CPI reading translates into a 1.3% rise over the past year. That’s slightly higher than the previous reading, although the rolling 12-month rate of change for CPI still looks weak, as the chart below suggests.

Rolling 12-month % change in headline CPI

After stripping away food and energy prices from CPI—leaving the so-called core rate of inflation that the Federal Reserve targets—the pricing trend looks considerably weaker. Indeed, core CPI rose a mere 0.1% last month, well below headline’s 0.3% gain. And for the past year, seasonally adjusted core CPI is up by just 1.0%--the lowest since the early 1960s.

Rolling 12-month % change in core CPI


It’s tempting to think that inflationary pressures have merely evaporated and that this is good news for the economy. Indeed, something close to stability on the pricing front is every central bank’s goal. But given the current profile of an economy that appears to be struggling to maintain growth, an unusually low level of core inflation raises questions about the potential for deflation if the economy weakens further in the months ahead.

Whatever concerns are suggested via today’s CPI report, anxiety is minimized somewhat by the news for July retail sales. Last month’s 0.4% jump reverses two straight months of declines. Much of the rise, however, is due to strong auto sales last month, which was reportedly driven by one-time incentives for buyers.

More importantly, the 12-month rolling pace of retail sales is still holding up, as the chart below shows. The annual pace of sales is sure to decline in coming months. Year-over-year comparisons look strong at the moment, but that's largely because last year's readings were unusually depressed. The question is how the trend fares from here on out. Much depends on the labor market, which for the moment is suffering from mediocre growth.

At best, July’s economic profile so far is mixed. Meantime, a fair amount of additional data for July is coming during the remainder of this month and so a complete reading is still up for grabs. For instance, next week brings updates on housing starts and industrial production, followed by July figures for durable goods orders the week after.



Meanwhile, retail sales offer a bit of optimism for thinking that the struggle for growth isn’t lost. It's hardly definitive, but it's all we've got for the moment. But after yesterday’s discouraging news on new jobless claims, it’s clear that the macroeconomic outlook is still cloudy.

One retail sales report certainly doesn't render the last several months of sluggish economic news irrelevant. "There is only one thing that's for sure -- economic momentum has slowed," Jennifer Lee, senior economist for BMO Capital Markets, told AP today.

But given the diminished expectations for the future, one could argue that today's numbers are a turn for the better, if only marginally and relative to pessimistic forecasts. "Consumers are still cautious, but it is not double-dip material," opined Stuart Hoffman, chief economist at PNC Financial Services Group, via Reuters.

Such is the realm of "good news" in the new normal.

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

Key Predictors Of Inflation Or Deflation

While inflationists and deflationists can support their arguments with select data about money supply and interest rates, the most important factor to watch, according to Moses Kim, is the dollar exchange rate. A loss in confidence in a currency can happen very quickly, as the Euro has demonstrated, and this can lead to rapid inflation. See the following post from Expected Returns.

The inflation vs deflation debate is one fraught with biases, misnomers, and rigid positions. What I've noticed is that both inflationists and deflationists selectively handpick data to support their respective positions. This is fine and dandy if your goal is to win an argument; but if you want to win as an investor, you must unemotionally interpret data.

If I had to, I could make a convincing argument in either direction since we are seeing both inflationary and deflationary forces. I don't believe there is much debate on this point. However, the successful investor doesn't tell you what is happening right now. The successful investor is constantly trying to foresee future events using a Bayesian approach to investing, incorporating data on an ongoing basis to adjust forecasts if necessary.

Interest Rates

At the very core of the inflation vs deflation debate are interest rates. Unfortunately, most people misunderstand the relationship between interest rates and inflation.

Interest rates are driven primarily by inflation expectations and default risk. This implies that interest rates can both rise and fall with good reason in both inflationary and deflationary environments. In other words, the relationship between interest rates and inflation isn't so simple as to say lower interest rates equals higher inflation or vice versa.

Inflationists will tell you that low interest rates are inherently inflationary. At the very core of this argument is the fact that low interest rates will induce borrowing, and by extension, speculation. To support their argument, they will show you a negatively correlated inflation and interest rate chart like this:



Deflationists will tell you low interest rates not only evidence deflation, but muted inflation expectations. To support their argument, they will show you a positively correlated chart like this:



As you can see, both deflationists and inflationist can point to statistically and historically valid data to support their respective arguments. Unfortunately, both sides are guilty of showing just a snippet of the overall picture. The inflation vs deflation debate is far more complex and goes well beyond just interest rates.

Money Supply and Inflation

Let me preface the following statement by saying I lean heavily towards the Austrian camp. However, there isn't a strong correlation between money supply and inflation in the short-term. This is key to understanding why a hyperinflationary collapse didn't materialize last year when money supply went through the roof.

In the early stages of inflation, money supply often outpaces inflation by many multiples. This was the situation in the Weimar Republic before their hyperinflationary collapse. The following charts taken from Constantino Bresciani-Turronis seminal text about the Weimar hyperinflation, "The Economics of Inflation", makes this relationship clear.






Notice that in the early stages of inflation, money supply outpaced domestic prices, import prices, and the dollar exchange rate. However, the situation in the Weimar Republic quickly deteriorated to the point where money supply, domestic prices, import prices, and the dollar exchange rate had a near perfect correlation. The public lost confidence in their currency and prices essentially "caught up" to money supply.

In 2009, Ben Bernanke cranked up the printing presses and the money supply expanded at an unprecedented clip, yet there was no hyperinflation. Inflationary forces were certainly concentrated in certain sectors, such as stocks, but on a broad scale, inflation was muted.



Recently the trend in money supply has reversed. According to John Williams at shadowstats.com, M3 is contracting at the fastest rate on record. This is an apparent victory for the deflationists, right?

Not so fast.

Dollar Exchange Rate

I believe the number one driving force of inflation moving forward will be the dollar exchange rate; and I believe the the loss of confidence in the monetary system as currently structured will lead the dollar down. History shows that the truly monster currency moves are driven by public confidence.

Remember, it was only a year ago that the Euro was the safe haven currency of choice for investors. The recent collapse in the Euro is correctly blamed on the debt crisis in the PIIG nations. However, the debt problems in the Eurozone were well known for years. The only thing that changed was perception.

Perception is the only thing propping up the U.S. dollar. Europeans thought they could waddle through their debt problems unscathed until, well, they couldn't. Americans are similarly inflicted with the head-in-the-sand disease that ignores large-scale funding problems similar to those seen in Greece. The dollar will continue to profit from safe haven capital flows until, well, it doesn't.

Swings in the dollar, and by extension inflation, will be sudden and dramatic, mirroring the confidence of investors. It will therefore benefit people in both the inflation and deflation camps to rethink their respective false assumptions. The fundamentals for dollar weakness have been in place for some time; it is now time for the market to recognize it.

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

Why Inflation Is Far Better Than The Alternative

James Picerno from The Capital Spectator discusses the options governments have in times of financial crisis, and why the Eurozone countries are choosing the option of inflation. While inflation is often given a bad name, the Great Depression showed us that the results of deflation could be far worse. See the following post from The Capital Spectator.

Fiat currencies ultimately succumb to the follies of government largess, but the denouement rarely comes quickly. So it goes that the rumors of the euro’s death have been premature.

No government will sit idle as its currency struggles with survival. The template for life-giving resuscitation is, in the 21st century, widely recognized and practiced, albeit in various forms with various results. But in the grand scheme of monetary policy, there are two basic paths available when a currency comes to the strategic fork in the road. One is to let the natural market forces have their way in times of economic contraction. This choice allows prices to settle on the point of equilibrium, which is to say fall. But letting supply and demand take control is political suicide at some point. Deflation, in short, is unacceptable to the citizenry, and understandably so in a world of debt. Did anyone really believe that the European Central Bank and the various governments on the Continent would allow Greece, a tiny sliver of the eurozone’s economy, bring down of the world’s leading currencies?

The solution, as any student of financial and economic history knows, is the time-tested device known as inflation. Fiat currencies are, by definition, a flexible beast. They exist solely by government decree. If the state has the power to create a currency, it also retains the power to revive it when economic turbulence arrives. Indeed, the raison d'etre of fiat currencies is to elevate inflation when the alternative is unacceptable. Reflation, in short, is every currency’s savior in times of turmoil.

The last time central bankers and governments attempted the alternative in any meaningful way was the early 1930s, when a variant of the gold standard was in force. Suffice to say, that policy path had its problems. As Barry Eichengreen writes in astute book Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, “the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.”

The gold standard is a potent tool for keeping a lid on inflation, but it’s not much use otherwise. No wonder, then, that when a currency (or an economy) needs inflation (or less of deflation), the gold standard can be downright lethal. The gold standard is the antithesis to a flexible monetary policy. That can be a net plus at times, perhaps most of the time. But it threatens heavy economic pain every so often, and every economy ultimately cries uncle at some point. In that sense, the gold standard is impractical since it's politically unacceptable at certain points in the business cycle.

The euro isn’t linked to gold, of course, but below every fiat currency is the potential to step closer to a de facto gold standard. The governments of Europe have been facing such a decision in recent months amid the collapsing fortunes of Greece. Tethered to the euro, the Greek economy is effectively chained to a gold standard, albeit one imposed by the folks in Brussels rather by the barberic metal. Devaluation of the currency (a.k.a. inflation) is impossible for Greece, just as it was for the U.S. in the early 1930s pre FDR. That shifts the pressure elsewhere. Economic adjustment is inevitable in times of crisis. If not with reflation, then where? In the 1930s in the U.S., under a gold standard, there was only one way out, as economics professor Randall Parker explains in The Economics of the Great Depression. In essence,

…economic agents should be forced to re-arrange their spending proclivities and alter their alleged profligate use of resources. If it took mass bankruptcies to produce this result and wipe the slate clean so that everyone could have a fresh start, then so be it. The liquidationists viewed the events of the Depression as an economic penance for the speculative excesses of the 1920s. Thus, the Depression was the price that was being paid for the misdeeds of the previous decade. This is perhaps best exemplified in the well-known quotation of Treasury Secretary Andrew Mellon, who advised President Hoover to “Liquidate labor, liquidate stocks, liquidate the farms, liquidate real estate.” Mellon continued, “It will purge the rottenness out of the system. High costs of living and high living will come down.”

Something similar awaits Greece, assuming it remains in the euro. The governments of Europe recognize the pressure and so they seek to ease Greece’s burden by offering reflationary support to ease the pain of the de facto gold standard. Nearly $1 trillion of reflationary spending is reportedly on its way.

In some respects this is a grand experiment. Can Europe maintain the euro, and its gold standard-like pressures on Greece and at the same time direct reflationary help to the ailing economy? To the extent that Greece represents a threat to the survival of the euro, it’s all but certain that European governments and the ECB will contain the threat. But at what cost? Greece will either be forced out of the euro (an unlikely scenario) or reflationary efforts will ease the pain by devaluing the euro vis a vis the dollar. Then again, the dollar has its own inflationary baggage if we look forward into the medium- and long-term future. Is one more burdensome than the other? The market has its work cut out for making a distinction.

The details will be messy, as they always are. But if the choice is inflation or deflation, we know how this story ends. Governments don’t willingly embrace deflation in the wake of the Great Depression, the last time that policy was embraced. Inflation is an easier pill to swallow…in the short term. There are long-term consequences, of course.

Inflation is always the preference since the Great Depression. There are some compelling reasons why that’s so. But it’s hardly a free lunch, even if it appears to be at the moment.

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

10-Year Treasury Yields Rise As Inflation Fears Resurface

The 10-year Treasury are climbing higher while signs of recovery, such as job growth, are becoming more and more prevalent. Many market commentators feel that interest rates are likely to continue to increase, especially since concerns about inflation are starting to become stronger. See the following post from The Capital Spectator.

As the benchmark 10-year Treasury Note inches higher, closing in on 4%, the chatter about interest rates and inflation is heating up.

The subject is all the more topical in the wake of last week’s encouraging jobs report. If the economy is gaining “momentum,” as former Fed head Alan Greenspan said yesterday, it’s only natural to expect higher rates. But how much is too much? The economy may be improving, but there’s still a long road of mending ahead. Warranted or not, the price of money is rising. As our chart below shows, the 10-year yield is just under 4%. That’s the highest since last June.

Are even higher rates coming? Yes, according to some bond bears at the outer edges of current forecasts. “Treasury rates will soar,” Kazuhito Miyabe, who assists with managing foreign fixed income in Tokyo at Toyota Asset Management Co., tells Bloomberg BusinessWeek.



Is inflation also headed higher? Not likely, at least not in dramatic fashion for the foreseeable future. The market outlook for inflation, based on the spread between the nominal and inflation-indexed 10-year Treasuries, remains modest at around 2.25%. That’s up sharply from the near zero percent range of late-2008, when the market feared a deflationary implosion. The low-2% range of late is merely a return to levels that prevailed before the financial implosion of September 2008. Yes, inflation's likely to creep higher, but it's unlikely to surge in the short term.

Nonetheless, this is no time for complacency on the matter of pricing pressures. Inflation appears to be bubbling, if only modestly, around the world. From Brazil to Australia, central banks are starting to focus on inflation. Rate hikes are still rare, but that too will change as the year rolls on. Consider, for instance, that Mexico, Brazil and South Africa, to name a few countries, have officially raised their inflation projections.

For U.S. policy, debating if inflation is, or isn’t, a clear and present danger going forward is topical within the Fed. As The Wall Street Journal reports today,

The Federal Reserve's decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.

But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.

The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.

Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures.

Expectations about future inflation may hinge on whether there’s a consumer-spending response to last week’s news of March’s robust round of job creation—the first significant increase since the Great Recession began in December 2007. Minting new jobs in substantial numbers is one thing. Will that lead to a material boost in consumer income and spending? Maybe, although we’ll need to see the March gain in jobs creation roll on through the spring and summer to make a convincing case.

Meantime, there are new hurdles looming, starting with this week’s Treasury sale of a hefty chunk of new government debt. Last week’s selling in the bond market, which drove yields higher, was an act of standing back to see what happens next, according to one strategist. “No one wants to stick his neck out before the auctions," George Goncalves, head of U.S. interest rate strategy at Nomura Securities in New York, told Reuters late last week.

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

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.