Inflation is under control

Unfortunately, the Fed hasn't yet figured this out, but I strongly suspect they will before too long. Meanwhile, standing pat, as the FOMC did today, is the least worst alternative to easing. Interest rates are relatively high from an historical perspective, but there are as yet few—if any—signs that monetary policy is too tight or that it is threatening the health of the economy. The fact that the year over year change in the CPI (now 4.0%) is still above the Fed's 2% target is meaningless, when a look under the hood shows that this measure of inflation will almost certainly fall to 2% (or lower) within the next several months. 

Chart #1

Chart #1 compares the 6-mo. annualized change in the CPI to the same change in the CPI less shelter costs. According to the latter, inflation has already fallen to 0.8%. As I have been arguing for the past several months, the measure of shelter costs (e.g., rents) used in the CPI lags the reality of the housing market by about 18 months. In the real world, housing prices have not increased at all over the past year, but the CPI is assuming they have been rising. So removing shelter costs from the CPI is entirely legitimate. Without shelter costs artificially inflating the CPI, inflation would already by significantly less than the Fed's target. And if that doesn't convince you, then look at the fact that over the past six months, the CPI has risen at only a 3.2% annualized rate, and it's almost guaranteed to fall further by the end of the year as shelter costs turn negative. 

Chart #2

Chart #2 shows the 6- and 12-mo. annualized change in the Producer Price Index for Final Demand. This index is comprised of things that inhabit the early stages of the inflation pipeline, and here we see that inflation is already comfortably below 2%. 

Chart #3

Chart #3 compares the value of the dollar (inverted) to the inflation-adjusted price of crude oil. Two things to note: commodity prices have a strong tendency to move inversely to the value of the dollar—a stronger dollar tends to push commodity prices down, and a weaker dollar tends to push commodity prices up. Today the dollar is relatively strong vis a vis other currencies, and commodity prices are generally weak. Crude prices are down almost 40% since last summer's peak, and the CRB Raw Industrials index (a broad measure of non-energy commodity prices) has fallen to levels which prevailed over a decade ago. In real terms, oil today costs about half of what it did a decade ago. Cheap energy can be a powerful tonic promoting economic health. 

Chart #4

Chart #4 compares the real Fed funds rate (the true measure of how high interest rates are) to the slope of the Treasury yield curve. Note that every recession on this chart was preceded by a huge increase in real interest rates (blue line) and a significant inversion of the yield curve (red line). Today the yield curve is definitely inverted, but real interest rates are not yet punishingly high, so by this criteria a recession is not yet baked into the cake. And as I've noted in prior posts, credit and swap spreads are still quite low, which also suggests that recession risk is low.

Chart #5

Chart #5 compares the level of the S&P 500 (blue line) to the level of the Vix (fear) index. Here we see that the market has been moving up from its low of last September at the same time that the Vix index has been declining from 31 to now only 14. Fears are subsiding and the stock market is breathing a sigh of relief. The market knows it is only a matter of time before the Fed wakes up and starts easing.