Keep Your Eyes Focused on Inflation’s Big Signals

by Bryan Perry | December 9, 2013 2:56 pm

As consumers and investors, we have entered a period in which many of the emerging markets are growing up and entering first-world status. The wave of those entering the middle class has created exponential demand for a better way of life, which has put long-term upside pressure on prices for just about every good and service we use.

When China entered the World Trade Organization in 2001, it was the sea change that kick-started this whole commodity boom that until just recently has shown a steady and relentless uptrend for food and energy prices, two of the most important components of any household budget.

The data on inflation released in October was tame and was talked up by the Fed because of lack of pricing power in a number of industries. Producers have done a masterful job of not passing on many of the raw-materials price increases — but those margins of safety are rapidly narrowing, and price increases for finished products eventually will have to be incorporated in the final demand equation if businesses are to show profits.

Just look at how the airline industry has remade itself in the past six years, making passengers pay for everything, even water. Despite efforts by producers of goods to keep prices down in a soft economy, inflation at the consumer level is alive and well for certain segments of everyday life, including health care and college education, for example.

Higher oil prices are probably the biggest driver of inflation in that they feed down through the supply chain into businesses. Everything that requires a transport to get a good or a service to market is going to feel the need to pass that cost on to end-user consumers.

Currently, oil prices are trending down; for how long is uncertain, but as the United States becomes more energy independent, big inflationary spikes due to a disruption in foreign oil supplies will be drastically reduced.

Do you remember when President Richard Nixon imposed emergency wage and price controls on the economy? He took this extraordinary measure in August 1971 because at the time inflation was seen as a national crisis. Prices of everything consumers buy were spinning out of control. Here’s the kicker: The inflation rate then was a mere 4.4%, based on the Consumer Price Index. Today, the annual CPI rate is hovering just above 1.0%.

But don’t be trapped into thinking 1.0% is nominal. The yield on a 10-year Treasury bond is now about 2.7%, and real interest rates would be higher if the Fed weren’t artificially suppressing them. Fed Chairman Ben Bernanke is now touting that the demand destruction in the U.S. created by productivity gains is hurting pricing power and that disinflation is a bigger threat to the economy than core inflation.

One thing you should be aware of is that statistical measures of inflation (like the CPI) are very slow to react because they reflect average prices across the whole economy. When there is inflation, many prices don’t adjust right away — such as wages for union workers who are under long-term contracts. So even though the CPI’s current 1.0% shouldn’t be alarming in and of itself, it actually underestimates the inflation that is currently building, but which has yet to infect the entire price structure of the economy.

What does make sense is keeping tabs on those measures that are closely correlated to inflation because they react to current conditions on a daily basis and reflect the true big picture for inflation. One such measure is the value of the U.S. dollar on foreign-exchange markets. Throughout history, when the dollar falls, it’s a precursor of inflation to come. Right now, the dollar has fallen 40% during the last five years. Today it’s as low as at any time in the last decade, and there is little to get in the way of it trading even lower if the Treasury keeps printing $1 trillion in fresh debt every year.

Again, the Fed has to keep interest rates artificially low in order to pump life back into the ailing credit and housing markets, but it is a dangerous game to play, given the rising tide of hidden costs. The bond market has been steady, with historically low interest rates persisting throughout this stable period for the Producer Price Index (PPI) and CPI. However, throughout most of the 1970s, when inflation was turning into hyper-inflation, 10-year Treasury bond yields never correctly anticipated the inflation to come.

Simply speaking, the Fed needs to raise interest rates when more evidence of inflation hits the tape, and eventually the Fed will have to make up for lost time with much larger rate hikes down the road than just a quarter-point, as has been its favorite move. Some things don’t change — and if the inflation genies are let out of the bottle, then late June’s gap move in interest rates will seem like small change.

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