It’s All Relative

Story Highlights:

• Energy and commodity prices have come off their highs, but they're still high, stoking fears of inflation.
• But inflation is a result of price increases, not static prices, regardless of levels.

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When it comes to the economy, and the markets, few words strike fear into investors' hearts like the dreaded I-word: inflation. Not surprising, since inflation can eat away at consumers' buying power, erode asset values and corporate profitability, and generally wreak havoc on the global economy.

And with food and energy prices through the roof lately, the fear is palpable, and it's influencing economic outlooks, central bank policy, market outlooks, and commodity outlooks. .

Europe Inflation Accelerates to 4% as Oil Prices Soar
By Fergal O'Brien, Bloomberg

Plosser: Fed Should Boost Rates 'Sooner Rather Than Later'
Staff, Associated Press

By Theresa Barraclough, Bloomberg

Malaysia Inflation May Quicken, Prompt Rate Increase
By Stephanie Phang, Bloomberg

Now, we beg your forgiveness in advance, but we're going to be black-hearted capitalists for a moment and look at the situation frankly. There isn't any doubting food and energy prices are higher and it certainly affects folks in adverse ways, but a well-reasoned analysis requires a degree of dispassion. And these days we see too much passion and not enough reason.

What is inflation exactly? Basically, it's the rise in prices for goods and services over time. Emphasis on rise. In other words, if prices, regardless of their current level, remain unchanged from any period to the next, the inflation rate would be 0%.

This seems a simple enough concept, but often folks have a difficult time seeing how a gallon of gasoline (for example) at $4 or more isn't inflationary. After all, it was only a few years ago they were paying half that amount. It's true the increase from $2 to $4-plus could have been a contributor to higher inflation. But other prices fell over the same period (in areas like real estate, technology and apparel), largely offsetting price increases in food and energy. So in aggregate, inflation has actually remained benign.

The real question now is where prices (for energy and everything else) will go from here because that's what determines inflation looking ahead. We expect the global economy to continue to defy the skeptics and carry on with the current expansion. This will mean continued demand for energy and commodities, and in the face of relatively fixed short-term supply, firm prices. But firm does not necessarily mean inflationary. When it comes to inflation, it's the relative move that counts: For energy prices to be inflationary, they would need to continue climbing from current levels. If they simply stay where they are now, that is not inflationary. Maybe commodity prices will move up a bunch from here, maybe they just hold firm around these levels. Either way, it's vital to understand their true effect on aggregate inflation.

But what about high energy prices starting a chain reaction to other areas? After all, every widget has to be brought to market—and whether by ship, plane, or train, the cost of transportation will increase. Eventually, so the argument goes, this cost must be passed on to the consumer.

This is an argument, anecdotally at least, which seems to make sense. But the effect of a price increase for one component of an end product can be hard to measure. If the cost of one piece reaches a certain level, substitution effects can take hold. In the instance of high transportation costs, a manufacturer might build a plant closer to its customer base, or source materials differently. And consumers can change their behavior as well, perhaps getting their bottled water from a local source (like the tap?) rather than say, Fiji. It's also well worth noting productivity has consistently and steadily advanced for years—a powerful ballast to inflationary pressures.

The best market indicators (long-term government bond yields and TIPS spreads) are for now quietly betting against a spike for inflation. See our recent cover story, "CPI: Rotten to the Core" 07/17/2008, for more.

Of course, it's worth keeping an eye on, but remember—when it comes to inflation—everything is relative.