Tuesday, June 14, 2011
Inflation at the producer level remains alive and well. Overall prices are up 7% over the past year, and they have risen at a 10.8% annualized pace over the past six months. Food, energy and commodity price gains comprise the lion's share of the gains, to be sure, but even excluding food and energy, the core PPI is up 2% over the past year, and inflation by this measure has risen at a relatively strong annualized pace of 3.5% over the past six months.
As I've mentioned before, it is noteworthy that both headline and core measures of inflation are accelerating, since this confirms that monetary policy is indeed accommodative. If the Fed were trying to keep inflation low and stable, then an increase in food and energy prices would force a decrease in other prices, with the result that core inflation measures would have to decelerate if headline price increases were accelerating. Yet that is clearly not the case today. The Fed is allowing non-energy prices to rise.
At the intermediate stage of processing, producer goods inflation is running at a blistering 17.3% annualized pace. As the chart above shows, we've rarely seen such rapid inflation in this measure. At the early stages of processing, crude goods inflation is chugging along at 22.5% over the past year. There is lots of inflationary pressure in the pipeline.
Perhaps the most significant conclusion to be drawn from all this is that prices are rising in many areas of the economy (and quite strongly), despite the fact that there currently is an unusually large amount of so-called economic "slack." (In my estimation, the economy is operating about 10% below its potential, meaning there are lots of underutilized resources, including many millions of sidelined workers.) This directly contradicts the Keynesian/Phillips Curve theories of inflation, and exposes a fundamental flaw in the Fed's thinking. Fed governors continue to believe that lots of economic slack will prevent inflation from gaining traction, and that's the only reason for the Fed to insist that it will keep interest rates very low for a considerable period. But as these charts suggest, by the time they decide to tighten policy, it may well be too late to prevent a sustained rise in inflation at all levels of the economy.
Investors need to draw several lessons from this. One, deflation is not a risk that one need worry about. Two, since Treasury yields are priced to the expectation that inflation will be very low and stable for a very long time, Treasuries should be avoided like the plague. Three, with inflation pressures building, investors need exposure to rising nominal GDP, which can be gained from equities, corporate bonds (since corporate profits are in large part determined by nominal GDP), and real estate. Corporate bonds will benefit from accelerating inflation since inflation tends to benefit debtors in general (and thus reduces default risk, to the benefit of the bond holder). As a corollary, high-yield and emerging market bonds should benefit the most since their issuers are usually highly leveraged. With real estate prices still down significantly from their 2006-7 highs, real estate might be considered undervalued given a rising inflation scenario. Precious metals are a classic inflation hedge, but their prices have already—in my view—anticipated a significant amount of inflation and are thus quite risky.
Posted by Scott Grannis at 10:28 AM