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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.

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