Monday, May 3, 2010
According to the Personal Consumption Deflator, the Fed's preferred measure of inflation (and a pretty decent one, I might add), inflation with or without food & energy remains within the Fed's target range.
Note, however, that inflation from 2004 through most of 2008 was consistently above target, and I think I know why. This period was preceded by all of the conditions that I have been worrying about for the past year. The Fed adopted a very accommodative monetary policy starting in late 2001, holding short-term interest rates below 2% through late 2004; gold prices rose from $260 in early 2001 to over $400/oz by late 2003; the dollar lost over one-fourth of its value against other major currencies from early 2002 to late 2003; commodity prices rose almost 60% from late 2001 to late 2003; and the yield curve went from being flat in early 2001 to almost as steep as it is now by late 2003. I consider that all of these signs are good leading indicators of rising inflation, and we have seen every one of them repeat over the past year or so: the dollar has fallen, gold has surged, commodity prices have surged, the yield curve has steepened, and the Fed has been holding short rates at almost zero for 18 months.
The one thing that is different this time around (history never repeats itself exactly, of course) is that for most of the past year or so the public's demand for money has been exceptionally strong. We saw the evidence of that in the big decline in velocity that occurred from late 2008 through mid-2009; in the big increase in currency in circulation and in M2 that occurred from late 2008 through March of last year; in the widespread signs of deleveraging in corporate America and among households from late 2008 through today; and in the very weak growth of bank credit.
In short, monetary policy has been exceptionally easy for the past 18 months, but the public's demand for money has been exceptionally strong at the same time. Monetary policy is inflationary only when the supply of money exceeds the demand for it. This is the essence of my rationale for why measured inflation hasn't yet increased, even though my favorite leading indicators of inflation are all pointing up: the Fed hasn't oversupplied money by enough to overcome the disinflationary aftermath of sudden and unexpected shock to confidence, a significant slowdown in economic activity, and the inflation "inertia" of the massive U.S. economy.
I note that rising inflation is now showing up in many Asian countries, and particularly in China. Most of them have effectively outsourced their monetary policy to the Fed by effectively pegging their currencies to the dollar. If U.S. monetary policy is inflationary, then it would makes sense that inflation would show up in smaller and less developed economies long before it showed up in the U.S. economy.
I think it is also worth highlighting the fact that despite the depth and severity of the recent recession, and the huge degree of "slack" or idle resources that have existed for most of the past year or so, there are no signs yet of deflation. The deflation that was predicted by popular (e.g., Phillips Curve-based) models of inflation was a total no-show. Recall that at the end of 2008 the bond market—via the mechanism of TIPS' breakeven spreads—was predicting significant deflation for years to come, yet instead we find that inflation has been running at a 1-2% rate for the past year.
In any event, and as Milton Friedman taught us, the lags between monetary policy and their impact on the economy are long and variable. That measured inflation hasn't risen yet, despite aggressively accommodative monetary policy and the appearance of a host of leading indicators of inflation, is not a reason to cheer. Investors can't wait for the signs of inflation to become obvious, since by then it's too late to react.
Prudence, a focus on the monetary nature of inflation, and a quick glance at the Fed's massively bloated balance sheet (which the Fed admits may take many years to reverse) should be enough to convince investors today to worry much more about inflation than deflation. That in turn should leave one more optimistic, not less, about the future prospects for growth in the U.S. economy (since the appearance of deflation could definitely weaken the economy, aggravate the burden of everyone's debt, and increase default risk), and it should make inflation hedges more attractive, not less. It should also argue against holding cash or cash equivalents.
Full disclosure: I hold no cash or cash equivalents, am long TIPS, long a variety of equities, long high-yield debt, long emerging market debt, and short Treasury bonds (via a 30-yr fixed rate mortgage) at the time of this writing.
Posted by Scott Grannis at 5:48 PM