Thursday, September 3, 2009
Conditions continued to improve in the service sector in August, according to the Institute for Supply Management's indices. As the top chart shows, we are not yet seeing robust conditions, but things have certainly improved from the lows of late last year. Perhaps more significantly, the prices paid component of both the manufacturing and service sectors shows strong gains in recent months. This is quite likely an indication that a) the Fed's super-accommodative monetary policy stance has not only eliminated deflation risk, but may be laying the seeds for higher inflation in the months to come, and/or b) the big decline in money velocity (i.e., cash hoarding) that caused the economy to nose-dive last year is beginning to reverse. If either or both of these forces are at work, that argues for continued, relatively strong gains in economic activity, cash flows, and inflation in the months to come.
The more we see things pick up like this without any indication from the Fed that it is going to start reversing its liquidity injections, the more nervous I get. To judge by the price of gold, which is now making yet another run at the $1000 barrier, and the dollar, which is quite weak, global investors need no encouragement to protect the purchasing power of their money.
Curiously, however, the bond market remains quite complacent about inflation, as reflected in a moderate decline in breakeven spreads in recent weeks. I've observed disconnects such as this in the past, and my intuition has usually told me to bet against the bond market when this happens. From long observation, I have become quite skeptical of the bond market's ability to correctly forecast inflation. The main reason for this is that both the bond market and the Fed (which has hero worship status for the bond market) believe that inflation happens only when the economy is "too strong." With the economy still decidedly weak, bond and Fed types conclude that inflation is impossible.
Posted by Scott Grannis at 9:12 AM