Wednesday, July 15, 2009
As was the case with producer prices yesterday, deflation was nowhere to be seen in the June CPI report. The headline CPI, heavily influenced by surging gasoline prices, was up at a 2.7% annualized rate in the first six months of this year, but the core rate (see above chart) was up at a 2.3% rate, almost as much. Both measures dipped in the final months of last year as commodity prices collapsed and the economy hit an air pocket. But so far this year things are back on track. If there was a deflation threat, as the market feared in late 2008, it hasn't materialized. For that we can thank the Federal Reserve for taking aggressive action to accommodate the surge in money demand that came in response to the credit and banking crisis, which in turn helped cause last year's air-pocket decline in the economy.
Even though the economy is most likely in the early stages of growing once again, there is by all accounts plenty of "slack," or idle resources. Yet this slack has had no visible impact on inflation this year. That reinforces my belief that inflation is not determined by the strength or weakness of the economy, but by the actions of the central bank.
The Fed should be taking note of this and raising interest rates. For months the evidence has been building that the economy was on the mend, that monetary policy had more than met the challenge of surging money demand, and that money demand was beginning to soften. We see the evidence in rising commodity prices, in gold prices trading at $940, in the dollar trading near the low end of its historic range, in a steep yield curve, and in rising breakeven spreads on TIPS.
To date there is little or no objective evidence that the Fed has committed any huge error. But the clock is already ticking on reversing the monetary expansion they so boldly engineered last year. They can't wait too much longer. Higher rates are not going to kill the expansion, they are going to instill confidence in the dollar and confidence is what is needed to power the economy right now.
Posted by Scott Grannis at 9:02 AM