Inflation can be a good indicator of economic growth. If growth is above long-term trend, then it is likely that inflation will be rising. If there is a negative output, there will be a bias to deflation. This very traditional Keynesian view still works as an effective rule of thumb. That does not mean that markets will always follow it in the short-run. Look at the increase in inflationary expectations during the Spring. This increase was driven solely by changes in expectations on the monetary side of the ledger. The output gap has a long way to go before it closes. Any thoughts that we are in robust growth should be tempered by the inflation news, down 2.1 greater than expectations of -1.9 and core inflation down to 1.5%. Nevertheless, we are seeing industrial production positive for the first time this year and capacity utilization slightly higher.
This makes for a bond market that is looking cheap. At a 3.59% 10-year, the real rate based on headline CPI is above 5.5%. if you look ta the core rate, we are at 2%. The 2-year Treasury is at 1.12% so the real rate is 3% and just slightly negative if you look at the core rate.
You are inclined to believe that bonds are cheap except for that little issue called the deficit. Recent research suggests that deficits do matter based on the shape of the yield curve. While the central bank may be able to keep short rates low, high deficits lead to a steeper yield curve which is what we are seeing now.
The gradual movement back to positive growth is occurring and being discounted in the market.
This makes for a bond market that is looking cheap. At a 3.59% 10-year, the real rate based on headline CPI is above 5.5%. if you look ta the core rate, we are at 2%. The 2-year Treasury is at 1.12% so the real rate is 3% and just slightly negative if you look at the core rate.
You are inclined to believe that bonds are cheap except for that little issue called the deficit. Recent research suggests that deficits do matter based on the shape of the yield curve. While the central bank may be able to keep short rates low, high deficits lead to a steeper yield curve which is what we are seeing now.
The gradual movement back to positive growth is occurring and being discounted in the market.
2 comments:
I have to believe that Inflation is going to rear its ugly head in the next few years. The arguments against inflation are the lack of spending by the American consumer, the largest part of GDP, as well as the lack of wage growth and overall "slack" on the production side of things. While I agree each of these is a factor working against inflation, these are all issues that could easily be reversed by more lenient lending, which the Treasury and Fed are working towards, and a return to growth in production, which we should see shortly as inventories have been depleted. If for no other reason, inflation is the indirect goal of the current monetary policy, as it gets the consumer (and Washington) out of debt faster. Nobody wants deflation, and you don’t want to “fight the Fed” in this case either.
Arguably, the high US and EU unemployment rates are a buffer, as is the wage deflation we’ve seen stateside. I believe that the coming bull market cycle (if we are in fact at the start of one) will return unemployment to the “natural full employment” levels of 5-6% over the next couple of years as companies begin to re-hire staff as they need to increase production. We have already seen hints of that in the UK, as firms are realizing they may have cut too many people too quickly. As US firms begin to realize the same, many industries will have to go back to the trough to add to staff. The knee-jerk reaction of drastic cost cutting will boost margins in the short term, but will in my opinion end up costing many companies more in the long run as they need to hire and train staff. While the worker has little pricing power today, in my opinion they will have much more power in late 2010-11 than they do now.
Concerning prices overall, it is an easy conclusion that energy, materials, and food prices are all going to see large price increases as the demand continues to come from China and India (and eventually return to the Middle East). Iron Ore and steel are putting upward pressure on prices, and while spot pricing will make the market more transparent and efficient, demand should only push costs higher to the consumer.
And finally, concerning food prices - Emerging Markets as a whole are eating much more meat per capita than ever before, which puts upward pricing pressure not only on livestock prices but also on all the corn and grain those cows and pigs eat. While supply can adjust to meet demand in the livestock part of the equation, the agricultural inefficiencies in the developing world will not be able to keep up with the coming demand for corn and grain. This is a much longer term trend, but imagine the cost of food around the globe as billions of Chinese begin to enjoy the fatty foods of the West.
I was more in your camp earlier in the year. The QE from the Treasury buying program looked like a sure sign that the Fed was willing to fight deflation with aggressive easing, but look at where we are at now.
1. The Fed program of buying Treasuries will end later his Fall.
2. Monetary aggregates are not growing that fast. In fact, there could be an argument that we are starting to see significant slowdown in aggregates like M2 and the old M3.
3. Loan demand is slowing. Banks cannot give money away to corporations.
4. The market is not using all of the Fed facilities available. There is no demand for credit.
5. The output gap is large and right now is not closing.
6. The demand for Treasuries is strong. This is due partially because the real rate of interest is surprisingly high.
7. Fed has been cautious especially with Bernanke up for reappointment.
8. TIP's implied inflation has been stable.
9. All of the increase in nominal yields are in the long-end, more than 5 years out. The market is saying that there may be inflation but it is going to take a lot more time than one or two years.
10. Dollar has been relatively stable.
11. Over-reaction on the downside for oil but market is more stable now at $60-$70 range. Many other commodity markets have been stable. Strong buying has been from China which has been exploding their lending. If there is an inflation issue, it may come from another source.
12. PPI and CPI headline risk still on the downside with deflation grinding to new lows.
Hard to say that we will have an inflation problem in the short-run.
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