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Thoughts on producer inflation

Once again the headline measure of Producer Price Inflation came in below expectations (-0.1% vs. +0.1%), with the result that on a year-over-year basis, this measure of inflation has been declining for the past 5 months. Unfortunately, that good news is fully offset by higher-than-expected core PPI inflation. And unless oil prices spike again, these trends are likely to continue. I note, for example, that the headline PPI is up a cumulative 40% over the past 10 years, while the core PPI is up only 20%; this divergence is bound to narrow over time, with the core measure catching up to the headline measure as higher energy prices slowly filter down to other prices.

One thing that should stand out here is that PPI inflation over the past 10 years (with a compound growth rate of 3.4% per year) has been and continues to be higher than it was in the previous 10 years (when the compound growth rate was 1.2% per year). And what has changed in the past decade? Monetary policy was undeniably tight in the 1990s, but the Fed has been working overtime to be accommodative for most of the past 10 years. That same message can be found in the dollar, which rose throughout the 1990s and early 2000s and has been falling for the past 10 years. It works like this: monetary policy impacts the value of a currency, and a declining currency eventually results in higher inflation.

Another thing that doesn't receive as much attention as it should is that Treasury yields have been lower than the rate of PPI inflation for most of the past four years. We haven't seen such low real interest rates since the highly inflationary 1970s, when the Fed was chronically "behind the curve," repeatedly failing to raise interest rates enough to constrain the high inflation that was triggered by the collapse of the dollar early in the decade.

Low real interest rates, a weak dollar, and an accommodative Fed are a combination that augurs for inflation that continues to surprise on the upside for the foreseeable future. In fact, that's been the case (higher than expected inflation) ever since the end of the last recession. Recall that at the end of 2008 the expected 5-yr, 5-yr forward annual CPI inflation rate embedded in TIPS prices was 0.5%. Instead, the CPI has averaged 2.1% a year over the past 3 years.

When inflation exceeds expectations and real interest rates are uncommonly low for several years running, this has distorting effects on economic activity. Since borrowing costs have been unexpectedly low and the returns to commodity investing have been unexpectedly high, it's not surprising that the mining and related sectors have been on fire, and commodity producers like Australia and Canada are at the top of their game. I wish I knew how much longer this will go on, but one thing is for sure: central banks are setting up the global economy for an inevitable and sharp correction in commodity prices and a return to rising borrowing costs.

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