Wednesday, April 15, 2009

Inflation is not dead

The "headline" measure of the CPI fell 0.1% in March, leading to much hand-wringing in the press about the lingering threat of deflation given the very weak state of the economy. Take away the seasonal adjustment factor, however, and the CPI actually rose 0.24% in March. Take away food and energy, and prices rose 0.17%. The big collapse in energy prices is the main thing depressing headline measures of inflation, but going forward energy prices are going to be adding to inflation, not subtracting. In times like this it's best to focus on "core" measures of inflation (ex-food and energy). As this chart shows, core inflation has moderated a bit, but it is still running in a 2-3% range.

Deflation was a threat in 2002 and 2003, due to the Fed's extremely tight monetary policy in the late 1990s. That's not the case right now, nor will it be for at least the next few years. Inflation is a monetary phenomenon, not a function of whether the economy is growing above or below its "potential." I've been saying for awhile now that inflation was likely to come in higher than the market was expecting, and so far I've been right. The market, and the Fed, believe that the weak economy will generate deflationary pressures. I believe that it takes tight money to generate deflationary pressures, and I don't see signs that money is tight.

Because the market is still so concerned about deflation, TIPS are priced relatively cheap to Treasuries. If inflation continues to be 2-3%, TIPS will beat Treasuries over the next several years. If inflation moves higher, then TIPS will do very well; nominal Treasury yields would likely rise while TIPS real yields held relatively steady, and the total yield on TIPS would rise with rising inflation.

Full disclosure: I am long TIPS and TIP as of this writing.

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