Inflation - It's Prices, not Price

Story Highlights:

• Given recent headlines and the Fed's accommodative monetary policy, investors are increasingly worried about inflation.
• A clearer understanding of what inflation really measures and use of appropriate indicators to monitor it helps alleviate the angst.

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Stocks were walloped again today. In fact, it was one of the worst market days of the last twelve months. Presumably, the sell-off was triggered by jitters over Bernanke's testimony to Congress.

Bernanke: Juice the Economy 'Quickly'
By Paul R. La Monica, CNNMoney.com
https://money.cnn.com/2008/01/17/news/economy/fed_bernanke/index.htm?postversion=2008011715

If you'd like more information on Fed-speak and MarketMinder's overall economic outlook, please see these past commentaries:

• Nothing New (1/15/2008)
• The Fed's Show and Tell (1/14/2008)

Today we're going to focus on inflation, another of investors' chief concerns. And why not—headline inflation ticked up and the Fed has been quite accommodative with money lately, lowering rates and holding special auctions for banks to get extra cash. The activity is pumping a lot of extra money into the system. So, will all the extra cash translate into higher prices?

A Delicate Condition
Economist
https://www.economist.com/finance-and-economics/2008/01/17/a-delicate-condition

Putting aside the notion of dreaded "stagflation" or even recession for a moment, there seems to be a lot of misunderstanding about what inflation really is. Inflation is the change in aggregate prices determined by a basket of goods over a period of time. The key word is "aggregate." So, rising oil rising doesn't necessarily mean inflation is too. Very often (and this is particularly true in today's world of climbing productivity and globalization) prices of other goods are falling. Electronics, for instance, are seeing steady price declines. This effect either mitigates the rise in price of items like food and energy, or sometimes wipes it out altogether. So while energy prices rise, it doesn't mean inflation has to also.

It's very important to think about inflation in this way because the prices of singular goods can swing widely on a monthly or even yearly basis. What matters most to an economy is the net effect of aggregate prices. That's one reason the Fed likes to look at "core" inflation, which excludes food and energy prices. A lot of folks will say "Hey, that's a cop out! Why not include food and energy? After all, we use those the most!" But those two items are highly erratic and skew the picture. Keep in mind extremely volatile items will skew results both ways. Higher oil prices made big contributions to headline inflation in the closing months of 2007—freaking out a lot of folks—but in the first weeks of 2008 oil dropped more than 10%! A drop that big will make headline inflation look very low (or possibly negative) in the months ahead.

Having the right perspective on inflation makes a headline like the one below appear a bit silly because, as even the article admits, "Higher costs for energy and food last year pushed inflation up by the largest amount in 17 years, even though prices generally remained tame outside of those two areas."

2007 Inflation up by Largest Amount in 17 Years
Associated Press, MSNBC.com

What are some alternative ways to monitor inflation? Well, we don't put much faith in traditional commodity-oriented inflation indicators like gold. Gold used to be a relatively reliable inflation indicator where folks held it to preserve their capital in times of rapidly rising prices. But that doesn't appear to be the case any longer. It's possible gold prices are near all-time highs at least in part because of high demand for the commodity itself. At best, the forces determining gold prices today are extremely murky.

A good place to look for inflation is the cost of risk-free debt through market-determined rates. Or, in much simpler terms, Treasury yields. If inflation is rising, yields on Treasuries should rise, and vice versa. Recall, for instance, the late 70s and early 80s where you could buy a Treasury bond yielding double-digits—a time of high inflation. Compare that with the last few decades, where inflation's held steady and Treasury yields came down along with it. Today Treasuries, if anything, are moving lower. (10-year Treasuries closed with a yield near 3.6% today.)

Some might argue it's because folks are purchasing Treasuries en masse due to a "flight to quality" on recession or credit crunch fears, thereby pushing prices up and yields down. Maybe. But even if true, TIPS spreads continue to point toward benign inflation. We quote from a recent Wall Street Journal article: "More telling may be what 10-year Treasury inflation-protected securities say about prices. These instruments, which fluctuate with inflation, are pricing in roughly a 2.25% annual increase in the consumer price index over the next 10 years…"

Bond Yields Defy Wisdom on Inflation
By Mark Gongloff, The Wall Street Journal
https://www.wsj.com/articles/SB120044943464493201

Now let's be clear: We're not necessarily saying inflation will be low for the next ten years. But this is a pretty clear and tested market indicator telling us inflation, at least for the time being, isn't a big issue. Note that MarketMinder regularly uses the term "benign" inflation. That's because a little inflation isn't a bad thing—it's rapidly climbing or very high absolute inflation that damages economies.

For today at least, inflation shouldn't be on your short list of economic or stock market worries. Could it balloon at some point in the future? Of course it could. But it's a low probability today and not one worth altering your portfolio over.