Wednesday, July 15, 2009

The deflation dog that didn't bark (2)

As was the case with producer prices yesterday, deflation was nowhere to be seen in the June CPI report. The headline CPI, heavily influenced by surging gasoline prices, was up at a 2.7% annualized rate in the first six months of this year, but the core rate (see above chart) was up at a 2.3% rate, almost as much. Both measures dipped in the final months of last year as commodity prices collapsed and the economy hit an air pocket. But so far this year things are back on track. If there was a deflation threat, as the market feared in late 2008, it hasn't materialized. For that we can thank the Federal Reserve for taking aggressive action to accommodate the surge in money demand that came in response to the credit and banking crisis, which in turn helped cause last year's air-pocket decline in the economy.

Even though the economy is most likely in the early stages of growing once again, there is by all accounts plenty of "slack," or idle resources. Yet this slack has had no visible impact on inflation this year. That reinforces my belief that inflation is not determined by the strength or weakness of the economy, but by the actions of the central bank.

The Fed should be taking note of this and raising interest rates. For months the evidence has been building that the economy was on the mend, that monetary policy had more than met the challenge of surging money demand, and that money demand was beginning to soften. We see the evidence in rising commodity prices, in gold prices trading at $940, in the dollar trading near the low end of its historic range, in a steep yield curve, and in rising breakeven spreads on TIPS.

To date there is little or no objective evidence that the Fed has committed any huge error. But the clock is already ticking on reversing the monetary expansion they so boldly engineered last year. They can't wait too much longer. Higher rates are not going to kill the expansion, they are going to instill confidence in the dollar and confidence is what is needed to power the economy right now.


Public Library said...

Ben Bernanke has already proven his ineptness. Don't be blinded by your optimism in man, for he is forever broken.

Next bubble here we come!

alstry said...


As you know wages are contracting dramatically....20% for CA state workers.

Commercial rents are in a free fall.

CRE values are imploding and bankruptcies are exploding.

Land is practically worthless.

Gasoline prices are a fraction of what they were last year.

Airline tickets are down.

Hotel rates are down.

I guess there is inflation and deflation, it just depends which glass you are looking at;)

狂猪 said...


I read this on the Brad Setser blog.

This analysis strongly suggest the USD is headed toward devaluation in a few years. If so, this will added to the inflation threat.

Any thoughts on an overall investment strategy that balance all the risks? I am long emerging market which helps to hedge the devaluation of USD. On the other hand, China for example, is already starting to get bubbly.

Scott Grannis said...

That was an excellent article on the dollar, thanks. I agree with most of what it says. I like the emphasis on dollar demand as being the key thing to watch. The dollar overhang story is basically the same as saying the Fed is going to be slow to withdraw its liquidity injections, mainly because they are not going to be able to respond to falling dollar demand in a timely fashion. If that is indeed what happens, then the dollar will fall because the Fed will have allowed a surplus of dollars relative to the demand for dollars. It's also basically the same as the rising inflation story. A falling dollar would be a key leading indicator of rising inflation.

These are all themes that I have been tracking. I think the investment consequences are many. It argues for being long commodities, long equities, long emerging markets, long real estate, long gold, long TIPS, and short T-bonds. One caveat: most of the major central banks are oversupplying their currencies these days, since their currencies are all falling against gold. So inflation could be rising all over the place, and that makes it difficult to recommend overweighting nondollar currencies. Emerging market currencies have done very well against the dollar, but their central banks and governments are not keen on appreciating much further.