Friday, September 19, 2008

Back to worrying about inflation

Now that the market is much less worried about a financial market implosion that leads to an economic collapse, it's turning its attention back to what I've been worrying about all along: inflation. Standard thinking (inspired by the Phillips Curve) says that if the economy is very weak, inflation will fall. That's why the bond market hasn't been too worried about $900 gold and $100 oil, because the weak economy would presumably take care of the inflation problem that these are symptoms of. This chart shows that normally, bond yields average about 3 percentage points above inflation. Right now bond yields are actually below the level of inflation (which means the market expects inflation to fall). But the Phillips Curve is not the best way to understand inflation. Monetary policy, not economic strength, is the cause of inflation, and the Fed has been pretty easy for a long time. If the economy continues to grow, look for the market to worry more and more about inflation. This relief rally has resulted in higher gold and oil prices, higher interest rates, and a weaker dollar, all signs that inflation is alive and well.

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