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Inflation picks up

The August rise in consumer prices exceeded expectations. The headline CPI rose 0.4%, vs. an expected 0.2%, while the 0.2% rise in the core rate was a tad higher than expected. As the first chart above shows, core inflation over the past six months is running at an annualized rate of 2.7%, while overall inflation is 3.6%. As the second chart shows, the rise in core inflation has been quite pronounced, and apparently owes a lot of its strength to the Fed's second round of Quantitative Easing which began almost a year ago.

What is most impressive about the rise in core inflation is that it has happened at a time when the economy has been demonstrably weak and the output gap has been gigantic (10-12% by my estimation). The main reason the Fed was so anxious to engage in QE2 was that it feared the output gap posed a serious risk of deflation. The bond market has been willing to ignore signs of rising inflation because of the pervasive belief that a large output gap provides an insurance policy against rising inflation. Yet these beliefs are being challenged almost daily. Thus, the Treasury market is perched very precariously on the edge of acceptable valuations, as real 10-yr Treasury yields are now clearly in negative territory.

Here's a Big Picture thought: what we see happening over the past year or so is the gradual undermining of widely-held theories about how the economy and inflation work. Keynesian economic theory is taking a beating, because it was used to justify a $1 trillion government spending stimulus package that not only failed to stimulate the economy as predicted, but most likely helped to weaken the economy. The Phillips Curve theory of inflation is also taking a beating, because inflation is much stronger than it has been predicting, given that unemployment is still very high.

The bad news for Keynesians and Phillips Curvers, however, is good news for supply-siders like me. Supply-side theory has been predicting relatively slow growth and a tepid recovery for over two years, since it recognizes that deficit-financed spending has no power to generate growth, and big increases in the deficit inhibit risk-taking because they tell the market to expect big increases in tax burdens in the future. (Two consistent themes of my predictions since early 2009 have been that the economy was likely to grow, but at a sub-par pace, and that inflation was likely to rise.) Rising tax burdens reduce the after-tax rewards to work and investment, so you end up getting less of both.

Monetarists and supply-siders have been predicting rising inflation for over two years, since they recognize that accommodative monetary policy, when fortified by a very weak currency, rising gold and commodity prices, a steep yield curve and low to negative real yields, will inevitably lead to higher inflation regardless of how weak the economy is. Indeed, in the supply-side framework, a weak economy is to be expected when monetary policy is inflationary. That's because easy money weakens a currency, and that increases the rewards to speculative activity while reducing the rewards to investment, and with weakened investment you get weak growth.

Along with the decline of Keynesian theories and the rise of supply-side theories, we are seeing a powerful realignment of political power in Washington. Obama, a dyed-in-the-wool Keynesian, is still insisting that what we need is more spending and more government control over the economy. But he is fighting a losing battle as more and more people begin to realize that Big Government is antithetical to prosperity. Keynesianism is all about giving power to politicians so they can pull the levers that supposedly will create growth, but now we see that politicians are fallible just like anyone and spending other people's money is never a very productive enterprise. Indeed, giving a handful of individuals who happen to inhabit Congress the power to spend a trillion dollars they don't have is so foolish as to be dangerous to our economic health.

What we can expect to see more of, fortunately, is policies that return power to the private sector, while also increasing the after-tax rewards to work and investment. Even if it takes a year or so for policies to make a clear shift in a more pro-growth direction, the prospect of improvement and the fact that in the meantime the economy is likely to continue to grow, should be enough to push equity valuations and Treasury yields higher.

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