One of the supporting pillars in the recent rally is the recognition that inflation isn’t a problem. Last year’s financial crisis knocked the stuffing out of the system’s tendency to devalue the purchasing power of fiat currencies over time. The net result is an unusual level of economic cover for keeping interest rates low–really low. Indeed, the primary goal of the Federal Reserve and its counterparts around the world over the past year has been the unbridled pursuit of higher inflation, though not necessarily high inflation.
In the depths of the crisis, the immediate objective was simply to deliver some level of inflation, which is to say something other than deflation. Allowing deflation to fester is simply too great a threat. The basic prescription has been printing money. How’s it working?
The good news is that deflation is no longer a clear and present danger, as it appeared to be late last year and into early 2009. Measured by the consumer price index (CPI), the official benchmark of inflation in the U.S., the last monthly decline in consumer prices overall was in March. There have two months with flat prices, but the general trend since the spring is up, if only marginally. In September (the last reported month), CPI advanced 0.2%, down from August’s 0.4% rise, the Labor Department reported. The latest CPI reading shows that consumer prices fell on a year-over-year basis, but that statistical quirk will soon fall away as we move beyond the events of 2008.
The October update on CPI arrives next week (November 18), and the consensus forecast is looking for a 0.2% rise, according to Briefing.com—unchanged from September.
Meantime, the Treasury market’s outlook for inflation is climbing. As our chart below shows, the implied outlook for inflation based on the spread between nominal and inflation-indexed 10-year Treasuries is now above 2%. This is the first sustained move above 2% since the financial crisis of 2008, save for a brief rise over this level back in June.
A 2% inflation rate is hardly the end of the world, of course, assuming the forecast proves accurate. Indeed, before last year’s crisis, the Treasury market was consistently predicting inflation in the 2.5% range. By that benchmark, the inflation outlook remains muted. Much of the recent rise is simply a return to levels that prevailed under less extraordinary times.
But expected inflation is a slippery concept, as is all other efforts at divining the future. What’s more, there’s no lone methodology for forecasting inflation, much less one that’s persistently accurate. Rather, the crowd is constantly reassessing the future and making guesstimates about what’s coming. But while we can debate exactly what constitutes a fair outlook for pricing pressures, the general trend is clear, as the chart above shows. Slowly but surely the market is raising its inflation expectation.
There’s some corroborating evidence that this is more than rank speculation. The gold market, for instance, has been pushing higher too. An ounce of gold now trades for roughly $1,100, a roughly 50% rise from a year ago. Meantime, the U.S. dollar has weakened over the past year. The twin trends suggest that inflation is on the rise, if only marginally.
That’s no surprise, given the Fed’s instinct and decisions over the past year. But in pulling the levers that engineer a higher level of inflation, the great question is whether Bernanke and company can slow and/or turn off the upward momentum in pricing pressure at the appointed time?
One of the Fed’s own, James Bullard, president of the St. Louis Fed, tells FT yesterday that for the foreseeable future “you have inflation that will be possibly substantially above target over a horizon of two to four years, and that, I think, is because of the combination of very large fiscal deficits in the US with very easy monetary policy.”
We keep hearing that the central bank shouldn’t repeat the mistake of the 1930s, when the Fed started raising interest rates too early, which derailed the nascent recovery. But it’s becoming clear that the problems of the moment don’t constitute another Great Depression. There are still huge challenges ahead, but they’re different challenges than those that confronted policymakers in the mid-to-late 1930s. Nor is it clear that interest rates just above zero are the magic solution to what ails us now.
One can make a case that it was easy money that got us into the current mess and that easy money isn’t necessarily going to get us out of the hole this time, as it seemed to in past business cycles. Yes, stabilizing the system was a priority over the past year, starting with preventing deflation. That battle seems to be won. Deciding what comes next, and what it means for portfolio strategy, is now the topic du jour, and it’s only just begun. Unfortunately, easy answers aren’t forthcoming.
As the FT story on Bullard advises,
Mr Bullard said historically the Fed had waited until two-and-a-half to three years after a recession ended before raising rates. That, he said, “would put you in the first half of 2012”. But the committee might take into account a wider set of factors this time, including the danger that ultra-low rates could fuel asset price bubbles.
“What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: ‘What does the output gap look like; what does inflation look like?’”