Tuesday, October 18, 2011

Producer inflation continues to surprise on the upside

The September rise in the Producer Price Index far exceeded expectations (+0.8% vs. +0.2%), bringing the year over year change in this measure of inflation to an elevated 7%. Actually, producer inflation has been pretty consistently exceeding expectations for the past several years. The best way to see this is to compare interest rates to inflation, which the bottom chart does by subtracting producer inflation from 10-yr Treasury yields. Treasury's real cost of borrowing, measured by the amount of inflation at the producer level, is now very negative: -4.8%. For the past few years, Treasury has actually been making money by borrowing at extremely low interest rates, because it can repay the debt with dollars that get cheaper at a rate faster than its cost of borrowing money.

With federal deficits now measured in the trillions of dollars, it may be of some consolation to know that the burden of the accumulating debt is already being addressed in part, thanks to accommodative monetary policy from the Fed. Unfortunately, inflating one's way out of debt does little if anything for the health of the economy.

Today's environment is disturbingly similar to that of the 1970s, when inflation invariably exceeded both the expectations of the market and of the Fed, the dollar was exceptionally weak, and gold and commodity prices were booming. Inflation expectations were slow to catch up to reality back then, and the same holds for today. The economy struggled in the 1970s, and it is struggling today, and the Phillips Curve thinking that drives inflation expectations remains deeply ingrained in the bond market: that's why the majority of observers—and the Fed itself—continue to repeat the mantra that with the economy so weak, inflation is bound to subside. But it doesn't. In fact, inflation has been accelerating for the past 2 1/2 years, even though the economy has been exceptionally weak. The reason, of course, is that inflation is driven by monetary fundamentals, not by growth fundamentals.

At the intermediate level, producer inflation is running at double-digit rates. It's important to note that the acceleration of inflation according to this measure has been underway since 2002, which (not coincidentally) happens to be when the Fed first began shifting to an accommodative monetary stance.

Complacency on the part of bond market vigilantes is an essential ingredient to a rising inflation environment, because inflation that is unexpected can have far more consequences than inflation that is expected. When the consensus of opinion finally comes to terms with the reality of rising inflation, that will lead to big changes on the margin, and those changes will push the prices of many things much higher. Individuals and businesses will scramble to borrow more (thus pushing interest rates higher), reduce their holdings of money, and buy more inflation hedges (in particular real estate, which is the most price-depressed of all tangible assets these days). Money velocity will turn up (because money demand will fall), which will cause nominal GDP to accelerate. Money demand is exceptionally strong right now, and it has enormous potential to decline in the years to come (see chart below). Accelerating nominal GDP growth will result in stronger-than-expected cash flows, which in turn will exceed the expectations of an equity market that today fears a collapse of future cash flows. So the future looks grim for Treasuries, but not so bad—and maybe even quite good—for equities.

Whether the Fed will be able to respond to rising money velocity/falling money demand by raising interest rates enough to short-circuit a further rise in inflation is the big question. The Fed's response to the rising inflation of the 1970s was always too little, too late, and this allowed inflation to accelerate to double-digit levels. But Fed Chairman Volcker finally figured out what needed to be done, and interest rates soared in the early 1980s. One way or another, interest rates are going to have to increase significantly from current levels; the only question is when. Either the Fed will raise rates, or a decline in money demand will push rates higher, or both.


McKibbinUSA said...

Scott, what suggestions would you have for central bankers to hammer out the remaining and/or rising inflation in the economy...?

Squire said...

A find your post compelling. I think “they” want inflation so I don’t see a strong response to inflation. Fed President Charles Evans said the inflation target should go to 3%.

I am thinking the market has bottomed most recently.

Benjamin Cole said...

And yet the example of Japan looms, and none of Grannis' observations panned out there.

Interest rates and inflation just died in Japan, and stayed dead, along with their real estate and stock markets.

The Bank of Japan kept interest rates at zero, just about. The nation borrowed heavily (through from themselves).

And inflation died, and they had mild deflation for 20 years.

So we know that keeping interest rates low does not lead to inflation in every case.

We may be entering an era of mild deflation and zero interest rates---the Japanification of America.

If so, expect your real estate to fall in value by about 80 percent in next 20 years, ala Japan. Your stocks will trade much lower too.

Scott Grannis said...

Benjamin: you keep flogging the dead Japanese horse, but you neglect one big thing: the yen is extremely strong, and has been strong for years, while the dollar has been extremely weak for years.

A very strong currency is consistent with deflationary pressures, but a very weak currency is not.

Benjamin Cole said...

BTW, the "core" PPI, without energy and food, was up only 2.5 percent in last year--as we crawl out of a recession. I wonder if many business are not really "inflating" their prices, but only "reflating."

In my corner of the world (cabinets, interior build-outs etc) many businesses had priced product and services to just survive and not even that. Enough businesses may be gone that the remainder are able to charge enough to survive. But it is definitely reflation, not inflation.

Real estate is still dead in the water--if ther si to be an inflation, no one in real estate seems to know it.

As in Japan---prices just kept going down, and then down some more--and down for 20 years and still going down.

A deflationary psychology sets in, then it is curtains for investors.

Jean-Pierre Deslandes said...

For my part I have believed for a long time that states would try to use inflation to counter their massive debt. The alternatives (austerity and taxes increases) just don't buy enough votes...

So the hidden tax we call inflation it will be.

Thank-you Scott for explaining how rates will go up either way (with or without central bank intervention)

As you say the question is when.

Care to venture a guess as to when that might be?

Benjamin Cole said...


You are right about the yen, but the dollar has been at this level a few times in the past, even in periods of low inflation and good economic growth.

The decrease in the exchange rate of the dollar might be tied to it coming down to its "market" trading range, as opposed to its trading value as a reserve international currency. Some say the dollar has been overvalued for decades, and I tend to think they have a point.

Oddly enough, we can still just print money and buy goods overseas with it. That reality may be inflationary---sure is an easy way to live.

Donny Baseball said...

If investors decided they wanted merely 0% real returns and they keyed in on the PPI - two assumptions I'm not sure about - does this imply that the 10yr yield has to rise 480bps for a negative 33% return????

Bill said...


Can you comment on the constant up and down movement of the markets based on whether the news is "good" or "bad" out of Europe? Will things only settle down (or collapse) when we know exactly how a Greek default affects other countries and their banking system as opposed to the rumor of the day about how the Euro zone intends to deal with the problem?

Scott Grannis said...

Donny: that's right. If inflation were to continue at 7%, I would expect 10-yr yields to rise to at least 10%. Investors wouldn't be happy with a zero real yield if they expected inflation to be that high.

Scott Grannis said...

Bill: Europe does seem to be the driver of all the ups and downs. This will likely continue until we get a definite resolution of the Greek problem, and I think that means an actual and significant default. Once that happens, markets may be able to focus on more long-term stuff and lose a lot of their current volatility. I have to think a Greek default is so fully expected that when it happens it will almost a non-event.

Benjamin Cole said...

The TIPS market is telling us that investors think inflation is dead. The property market is telling us that real estate buyers think inflation is dead (they are not really buying even with 4 percent money).

Okay, I talk about Japan too much. But the fact is,. low interest rates alone will not re-ignite the economy--we know that from Japan.

Scott Grannis has correctly pointed out that the yen has appreciated in the last 20 years, about double to the dollar.

That proves you can have very tight money and zero interest rates. And all the while, property values will sink, even for 20 years in a row.

I fear we are lumbering into the Nipponese economic cul-de-sac.

The way out of the Rising Sun cul-de-sac is call nominal GDP targeting, or Market Monetarism.

Basically, under Market Monetarism, the Fed says it unhesitatingly will use all tools, conventional or otherwise, to hit nominal GDP targets. The nominal GDP target (rules-based target, btw) is more important than interest rates or inflation.

I encourage all concerned to learn more about this approach to monetary policy.