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Tuesday, January 18, 2011

What's Up With Inflation?

The most recent CPI report was greeted with a yawn despite some potentially ominous signs. The overall CPI-U (CPI for All Urban Consumers) rose +0.5% for the month of December and +1.5% for the 12-month period. The 12-month number is below the implicit Fed target of 2%. Take out food and energy, and the numbers are even softer - +0.1% for December and  +0.8% for the 12-month period.

Thus, if you stayed home and fasted you were not, apparently, much affected by inflation in December or, for that matter, the whole year.

It should be noted for the record that the general population is having a hard time believing these numbers. Tell most people that inflation is practically not existent and they will look at you like you're crazy. But then again, most people eat and drive and use energy in all sorts of forms.

But the past is the past, and what we are interested in is seeing if there is not some investment insight from all of this, i.e. could inflation increase more than expected?  I happen to believe so. Let's go back to the early 1980s when the situation was flip flopped. Here is a graph of the period 1975 to 1982 of the CPI:

Source: Economagic

In the early 1980s, right after Volcker's so-called "Saturday Night Massacre," in which he changed monetary policy from controlling interest rates to controlling the growth rate of the money supply, prices started falling and nobody believed it. Why? Because, as shown in the graph, inflation had consistently ratcheted upwards as shown by the red line which is the year-over-year change in the CPI. But people who were actually shopping for groceries were seeing the prices start to come down.

In fact, I attended a meeting of money managers in downtown Washington D.C. right around this time, at which a prominent economist from Merrill Lynch took a poll from the podium on how many in the room believed that inflation would fall. If you squint as you look at the graph, you see that inflation was at approximately 12.5%. As I recall, only 1 or 2 hands went up out of maybe 60 investment manager attendees!

Source: Economagic
The rest, of course, is history as can be seen in the graph on the left, which shows the CPI since 1980.

I present all of this because it seems to be the flip side of what we are experiencing today. Most economists see no inflationary pressures in the near future.  Although energy costs are rising, they aren't seen as a problem. In fact, the last time oil rose above $100/barrel, supply eventually drove it back down. Investors should note there was also another development - the nastiest economic downturn since the 1930s. Today oil is rising, and we are at the beginning of a global economic recovery.

The bottom line of all of this is that I believe investors need to be careful in here because inflation could come sooner and be more feisty than expected. It is important to look at investments and question how they will perform if this turns out to be the case. In particular, longer term fixed income instruments could be problematic.

Better safe than sorry!


  1. What do you think would happen if the rates started to rise again? Although demand explains part of the picture when it comes to oil and commodities, it seems that much of the inflationary pressure is off the back of easy money. I believe that rate hikes could lead to a sharp reversal here, but that might also be why such rate hikes could be slow in coming.

  2. As long as rates rise somewhat gradually and over time I think we'll be fine except for those invested in longer term bonds. Commodities and oil will do well in an inflationary environment and, as you point out, with demand will do even better.
    When the U.S. hikes rates the bond market will likely freak out for a couple of days because Fed moves tend to persist. In other words it wouldn't be just a one time thing. Also, when it comes the employment picture will be improving and the market is a bit fearful of pressures resulting from that.
    At least that's my take.

  3. I just posted the inflation segment of Friedman's Free to Choose series. Look at commodity prices. They have been rising steeply. Inflation is coming and is already here at the grocery store.

  4. I agree and the thing is that it could take a while for people to accept it. To me both the overall rate and the core rate are important. I think sometimes policy wonks like whichever one is better.

  5. Crap. I hate your last line although I figured that's where you would inevitably go. I guess this makes the case for watching those allocations!!!