Thoughts on inflation and growth

This chart shows the 6-mo. annualized rate of change for the headline and core versions of the Personal Consumption Expenditures Deflator, the Fed's preferred measure of inflation. Both measures of inflation now equal or exceed the Fed's professed inflation target of 1-2% on the core measure of inflation. Note also that both measures exceeded the Fed's target most of the time from 2004 through 2008. That period, of course, was one in which the Fed pursued very accommodative monetary policy because the economy was perceived to be relatively weak and deflation was thought to be a threat.

As I mentioned last week, the GDP revisions that resulted in lower growth and higher inflation must have come as quite a surprise to the Fed, especially since the Fed holds to the theory that very weak growth (and growth well below potential) should result in lower, not higher inflation. Now, not only has inflation turned up when it should have turned down, but the Fed's understanding of what makes inflation tick has been called into question once again.

This is not to say that we have an alarming amount of inflation on our hands, because we don't, at least according to the official inflation statistics. The important thing here is that the Fed's theory of inflation (aka the Phillips Curve theory of inflation) has not done a good job of predicting or controlling inflation. Meanwhile, the classical theory of inflation—that it is fundamentally a monetary phenomenon and has nothing to do with how strong or weak the economy is or whether there is a lot of resource slack or not—has done a much better job. There has been abundant evidence for some time now that the Fed was being too accommodative by supplying more dollars to the world than the world wanted. The evidence has been in plain sight, and supplied by market-based indicators: the very weak dollar, the rising prices of gold and commodities, the very steep yield curve, and the rise in inflation expectations as embedded in TIPS prices.

The classical view of inflation says that as long as the evidence points to a surplus of dollars in the world, then inflation will tend to move higher. So once again I conclude that investors should pay more attention to the risks of higher inflation rather than to the risks of deflation. That translates into a preference for asset classes with exposure to rising prices, such as equities, real estate, and commodities. At the same time, it argues for extreme caution in regards to Treasuries, especially since they are trading at very low yields. Treasuries have done very well of late, but that is not a reason to like them, since the lower yields go the more than prices stand to fall in the future if inflation does indeed move higher.

Finally, this analysis also suggests that the Fed is going to find it very difficult to justify another round of quantitative easing. There's too much inflation and too much uncertainty right now about where it's headed (did I mentioned the huge increase in the volatility of inflation in the past decade that is evident in the chart?) for the Fed to risk another massive easing effort. The economy is not at all starved for liquidity; there is plenty of money out there.

What is lacking is the willingness of investors and corporations to risk their money in the pursuit of new and productive ventures. There's not enough confidence in the future, there's too much concern about increased regulatory and tax burdens, and there's too much concern about the future value of the dollar. When those concerns subside, new investment and stronger growth should follow.