Tuesday, May 18, 2010

Inflation is still alive and well

The Producer Price Index of finished goods in April fell 0.1%, but only after rising at a 7.3% annualized rate in the past six months, and 5.4% in the past year. Excluding food and energy prices, the core PPI has been rising at a fairly steady 1% annual pace since early last year. So food and energy prices have been the major sources of inflation for the past year, but that doesn't mean inflation is dead.

If monetary policy were being run with the objective of keeping overall prices steady, then a significant rise in the price of one good or service would necessarily result in a significant decline in the prices of some other goods or services. With the above chart we see instead that big increases in food and energy prices did not prevent all other prices from rising. To the contrary: I note that prices of intermediate goods ex-food and energy have risen at an 8% annualized pace over the past six months, and 5.6% over the past year, while crude goods prices ex-food and energy are up at a whopping 48% annualized pace in the past six months, and 50% in the past year. Consequently we can conclude that the Fed is not pursuing a policy designed to deliver price stability.

The fact that inflation is still alive and well despite the huge amount of economic slack that has prevailed for the past 18 months also casts even more doubt than already existed on the still-popular Phillips Curve theory of inflation. Surely, if inflation had anything to do with the unemployment rate (the Phillips Curve posits an inverse relationship between the unemployment rate and the rate of inflation), then we should have seen plenty of evidence of deflation by now. To be sure, there are sectors of the economy that are experiencing price declines, but as the PPI numbers show, the overwhelming majority of prices are rising.

I've been arguing for quite some time that inflation is alive and well, and I think this is a significant issue. That's because the market continues to be very concerned about the risk of deflation; I see this in the relatively low 1.25% breakeven spreads on 2-year TIPS; I see it in the relatively low level of Treasury yields in general (2-yr Treasuries at 0.8%, 5-yr at 2.2%, 10-yr at 3.4%); and in the Fed's continued concern over deflation risk (why else would they insist on keeping short-term rates at close to zero?). If the market and the Fed were to lose their preoccupation with deflation risk, then the outlook for the economy and for corporate profits would brighten considerably, and default risk would decline. This would be undeniably good news for stocks and corporate bonds, and very bad news, of course, for Treasury notes and bonds, and for mortgage-backed securities. Furthermore, I suspect that if the Fed acknowledged that deflation risk were dead, the gold market would get a big case of the willies, because that would mean that super-accommodative monetary policy—the lifeblood of quadruple-digit gold prices—was on its way out. By the same logic, this would be a boon for the dollar, which remains historically weak.


Benjamin Cole said...


If I read this chart correctly, the core rate of inflation for the PPI is now under one percent.

I believe in prudent monetary policy, but when the core rate is under one percent, when property is selling for half off, and you have 10 percent unemployment....maybe we can run the printing presses for a while

John said...


Scott makes some good points with the PPI being up. Food and energy can be very volatile, which is why many pay more atten to the core number.

I continue to believe inflation as we have experienced in past decades is still 'out there' somewhere in time. However these things can change quickly and we need to be vigilant.

I have been using November as my time frame for the Fed to begin the long awaited tightening cycle. It now appears Europe's currency issues could prolong it into next year. A premature rate hike would not be helpful to the Fed's European counterparts.