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PPI inflation of 3.5% points to higher yields ahead

January Producer Price Inflation was lower than expected, but the core version was higher than expected. Nothing scary here, thank goodness, but on balance, inflation at the producer level is running at a rate around 3.5% per year. As the second chart shows, this is roughly the level of inflation that we have seen for the past 8 years, and it is about twice the rate that we enjoyed throughout most of the 80s and 90s. We likely are still in a somewhat higher, more volatile inflation environment than we saw during the Greenspan era. Given the weakness in the dollar and the strength of gold and commodity prices, and the Bernanke Fed's continued emphasis on being accommodative, I still believe that the risks to inflation in coming years are on the high side.

Treasury yields remain very low relative to the current level of PPI inflation. This creates incentives for firms to borrow and invest in raw materials, since the after-tax cost of borrowing has been much lower than the rate by which commodity prices have risen over time. It also makes it less likely that the Fed is going to be able to keep Treasury yields as low as they would like. With the economy showing clear signs of picking up, and inflation still alive and well, there is increasing pressure on Treasury yields to rise. I find it very difficult to believe that the Fed will be able to keep its "promise" to keep short-term rates close to zero for the next three years. When the Fed backs off of that promise, that should provide a further boost to confidence as yields rise to more normal levels.

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