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Consumer price inflation is heating up

Today's release of March consumer price statistics was unsurprising to the market, with headline inflation coming in as expected (0.5%), and core inflation coming in a bit below expectations (0.1% vs. 0.2%). On a year-over-year basis, headline inflation was 2.7%, while core inflation was a mere 1.2%. Both measures are below their long-term averages. 

But looking under the surface, the news is not all that rosy. Over the past six months, the CPI has increased at a 4.7% annualized rate, well above its long-term average, and reminiscent of the heady inflation we experienced in the 2004-2007 period. Over the past three months, the CPI is up at a 6.1% annualized rate. It's thus quite likely that the year over year CPI figure will exceed its 30-yr average (3.1%) by a comfortable margin before this year is out.

Even the core CPI is showing some underlying acceleration, with prices up at a 2% annualized rate over the past three months, and a 1.4% annualized rate over the past six months. It is noteworthy that both the core and the headline rates of inflation are accelerating at the same time. If monetary policy were non-inflationary, then the strength in food and energy prices that are driving the headline inflation index higher would be offset by declines in non-food and energy prices. But that is not happening—all prices are accelerating. This confirms that monetary policy is in fact accommodative, and that is exactly what the Fed is trying to achieve. The Fed wants inflation to move higher, and they are getting their wish. There is every reason to believe that this will continue for at least the balance of this year, since monetary policy operates with a lag and the Fed has made no move yet to tilt policy in a restrictive direction.

Investors will be interested in the behavior of the non-seasonally-adjusted CPI, since the interest payment on TIPS (Treasury Inflation-Protected Securities) is based on changes in that measure of inflation, with a two-month lag. The chart above shows the 3-month annualized rate of change of the CPI (nsa). It also illustrates the seasonal tendencies in the CPI: inflation typically reaches a low point around the end of every year, then a high point around March-April of every year. As should be evident, the seasonal low last December was a good deal higher than it has been for most of the past decade, and the recent high is almost as strong as any we have seen in the past two decades. In the first quarter of this year, the raw CPI is up at a 8.1% annualized rate. This means that the inflation adjustment that TIPS receive will be unusually strong on an annualized basis over the next few months, and possibly for longer.

The ongoing rise in China's inflation rate is making headlines today, but U.S. inflation is not too far behind, as this chart shows. It's not surprising that inflation should be moving higher both in China and the U.S., since China has essentially outsourced its monetary policy to the U.S. Federal Reserve by pegging the yuan to the dollar. Chinese inflation is somewhat more volatile than ours, and that is also not surprising since its economy is smaller and less burdened by long-term supply and labor contracts. If China has an inflation problem, then so does the U.S. It will just take longer for the problem to become obvious in the U.S.

Industrial activity enjoys strong growth worldwide

Since hitting bottom in June 2009, US manufacturing production has risen at a 7.4% annual rate, and has now recovered about half the ground that was lost to the 2008-2009 recession. That still leaves a lot of room for improvement, but there is as yet no sign that the pace of growth has diminished. At the current rate, manufacturing production will have made a full recovery within the next 18 months.

As this next chart shows, U.S. industrial production has been growing at about the same robust pace as Eurozone industrial production since the end of the recession, with both up at about a 5% annual pace in the past six months. The recovery is proceeding at a decent pace almost everywhere, and there is no reason at this point to doubt that this will continue. To be sure, the level of industrial and manufacturing activity remains depressed relative to previous highs, but it is the change on the margin (which is proceeding at an above-average rate) that is the important thing to focus on. Things are getting better at a decent clip, and will likely continue to do so. There are lots of good things to look forward to.

Swap spreads reflect low systemic risk

Swap spreads are excellent leading indicators of systemic risk, and thus very important things to track, which is why I continue to update this chart from time to time. As the chart suggests, conditions in the U.S. are just about optimal from a systemic risk standpoint: there is no shortage of money, default risk is low, and bank/counterparty risk is minimal. Conditions in Europe are still a bit unsettled, but they are slowly improving; the market continues to worry about sovereign debt default risk and its possible spillover effects, but swap spreads are saying that this risk is manageable and unlikely to prove seriously contagious.

Producer price inflation continues to accelerate

At the producer level, rising inflation is now unmistakable and indisputable. Even excluding food and energy, producer prices have been rising at a 2% annual rate since the beginning of last year, after rising by only 0.9% in 2009. Moreover, core producer prices rose at a 4.2% annualized pace in the first three months of this year.

This chart plots the producer price index on a semi-log scale, in order to highlight the different inflation regimes of the past several decades. Producer price inflation now appears to be accelerating beyond the 3.5% annual pace which prevailed from 2004 through last year, and far beyond the 1.7% annual pace which prevailed for the preceding 20 years. Over the past six months, the PPI is up at an annualized pace of almost 11%; over the past three months, prices have risen at an astounding 13% annualized pace.

These charts are an early-morning wakeup call that continues to be ignored by groggy Fed chairmen.

Weekly claims point to continued, but slow progress

First time claims for unemployment last week unexpectedly jumped, but this is entirely within the range of normal volatility for this statistic. On a four-week average basis, which is the preferred measure since it helps deal with the frequently-occuring problem of random blips, there is no sign of any meaningful change in what still appears to be a declining trend.

In this next chart, which uses unadjusted data from two weeks ago, we see an encouraging trend toward fewer people receiving unemployment insurance. Still, Congress' repeated extensions of benefits have likely had the unintended effect of prolonging this recovery, since on the margin a longer benefit period reduces the incentives of the unemployed to find and accept new employment.

Higher interest rates will not be bad for stocks

Many observers and investors worry that stocks are going to be hit when the Fed starts to raise interest rates, especially if they move too soon to tighten. I've maintained for a long time, in contrast, that an early tightening of monetary policy would be good for stocks. This chart shows that investors' fears are not necessarily well-founded.

The ECB last week surprised the world by moving sooner than expected to lift its short-term interest rate target. I wrote last week that this was a good thing, and noted that pre-emptive monetary policy tightenings have been very good for the euro, the Aussie dollar, and the Canadian dollar.

The chart above extends that observation to the stock market. German 2-yr yields, which are the market's best guess for what the ECB's target rate will average over the next 2 years, have soared from a low of just under 50 bps in June, 2010, to now almost 190 bps. This move was driven by the ECB's sooner-than-expected tightening of monetary policy, and the rise in rates closely parallels the new-found strength of the European stock market.

This is not surprising, of course, since a central bank's moves are almost always a complicated dance between the market's perception of the economy's strength, and the central bank's perception of that same strength. Sometimes the market signals the central bank that a move is Ok, and sometimes the central bank guides the market. In recent months the European economy is looking better, the central bank is more concerned that inflation might be picking up, and the market is happy that the ECB is not going to slip behind the inflation curve without a fight.

I would anticipate, therefore, that an earlier-than-expected tightening move by the Fed would be greeted with similar enthusiasm. Tighter policy would acknowledge that the economy is in better shape, and at the same time reassure markets that the Fed is anxious to stay on top of things, rather than fall further behind the inflation curve. Confidence in the future, and confidence in one's currency, are very important sources of support for equity prices.

Federal spending again outpacing revenues

Here's my monthly update of the Federal government's finances. After some 18 months of improvement, during which time spending was restrained and revenues grew at a respectable rate—thanks to rising employment, strong productivity growth, strong corporate profits and a rising stock market—spending has once again perked up, sending the 12-month deficit to $1.4 trillion. 

The recent budget agreement will do little to change the reality of a looming fiscal trainwreck. And even if the fiscal gap is eventually closed via higher taxes, the burden of government, as Milton Friedman taught us, is found in spending, not taxes or borrowing. If the government continues to spend 25% of GDP, the impact on the economy will not be mitigated by taxing more and borrowing less. Indeed, taxing more would probably be harmful to the economy in the long run, since it would immediately reduce the after-tax incentive to work and invest. Plus, as my mentor Art Laffer always used to say, if you had the choice of paying more taxes to the government or buying Treasury debt, wouldn't it be much better to lend the government the money? At least then you would have the hope of getting your money back, and with interest. In the end, whether the government borrows 10% of GDP or taxes an extra 10% of GDP, the federal government will end up spending the extra money in a way that will surely be less efficient and more wasteful than if the money had remained under the control of private interests. Friedman also reminded us that you never spend someone else's money as frugally and wisely as you spend your own.

The long-term outlook for the economy will only improve to the extent Congress is able to restrain the growth in spending. As I've pointed out before, simply freezing spending at current levels would balance the budget in about 5 years. 

I think this can be done, and I think the recent budget agreement was the first step in the right direction. I note that the whole nature of the fiscal debate has changed 180ยบ: the question now is how much and what to cut, not whether to cut spending. Consider Obama's amazing chutzpah when he praised the recent deficit reduction, just months after proposing the most outrageous deficit-ridden budget in recent memory.

Pulse of Commerce Index still looking healthy

The Ceridian-UCLA Pulse of Commerce Index, "based on real-time diesel fuel consumption data for over the road trucking," jumped significantly in March, erasing what was looking like a very soft patch or even the beginnings of a downturn since mid-2010. The softness earlier this year probably reflected the awful weather back East. This index is consistent with moderate growth of about 3%, which is what most people seem to be expecting these days. I'm seeing more growth downgrades than upgrades, but I remain optimistic that the economy is going to be picking up strength as the year progresses. There is no reason for concern here.

Trade continues to be a bright spot

U.S. trade with the world continues to expand, and that is reason for cheer. Exports have now made a complete recovery from pre-recession highs, growing at double-digit rates in the past few years. If nothing else, this suggests that exports have picked up a lot of the slack that was left by the housing and construction collapse; the U.S. economy is changing dynamically in response to an unexpected and massive shock. Imports are closing in on their prior highs, reflecting a relatively robust recovery in consumer demand in the U.S., which is impressive since employment is still far below prior highs.

A new high for metals

Another unpleasant milestone of sorts: this index of industrial metals price hit a new all-time high last week. The commodity price rally is not over, it would appear, and it is likely being driven by a combination of strong global demand which exceeds the capacity of commodity producers to meet, and accommodative U.S. monetary policy. The latter is playing a more important role these days, as the dollar continues to slide. Importantly, I note that metals prices are still well below their 2007-8 highs when priced in yen, euro, swiss francs, or sterling. Metals prices are relatively strong when compared to their historical ranges, but the bigger news is that the dollar is exceptionally weak. This can only aggravate inflationary pressures in the U.S.