Tuesday, July 14, 2009
Given how miserable the economy has been, and considering the prevailing view that significant economic weakness is a source of deflationary pressures, many observers were likely quite surprised this morning when the government announced that the Producer Price Index jumped 1.8% in June, and is up at a 4.2% rate so far this year. The core (ex-food and energy) PPI index was up 0.5% in June and is up at a 2.0% rate year to date. Both measures of producer prices rose far more than expectations in June.
One big and overlooked story this year has been the failure of deflation to appear. Recall that by the end of last year the market was obsessed with deflation risk; TIPS breakeven spreads were priced to the expectation that inflation would be negative for many years to come. Well, it hasn't happened—in fact, just the opposite. This is big news.
I've been emphasizing this for many months now, since it leads to some very interesting conclusions. For one, the evidence is disproving the Fed's theory of inflation; that in turn means that the Fed has probably been too easy because they've been overly concerned about the risk of deflation. With no shortage of money (another favorite theme of mine since last year), it is hard to see the economy going down the tubes. Two, rising prices are likely reflecting rising demand in addition to an abundance of money; that means the economy is probably doing better than most people give it credit for. Three, T-bond yields are probably underestimating future inflation, and that means yields could continue to rise as the year progresses. Four, an abundance of money coupled with rising demand is very good news for all those companies and countries with lots of debt, since it increases their expected future cash flows. It's not surprising therefore to see that credit spreads have contracted significantly and emerging market debt has done very well this year.
Posted by Scott Grannis at 12:20 PM