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Let me start by confessing something which most readers wouldn't like. I believe in the old fashioned definition of inflation. This definition requires that the price of things have to go up, and not just in pockets. It has to go up for a basket of goods and services that the average consumer purchases. Some of the goods and services will go up, others will be down, and the total increase in prices would be the measure of inflation. This, by the way, is how the Consumer Price Inflation metric is calculated, more or less. I simplify, of course, but the principle is the same.

This has not made me very popular.

Mention CPI in polite company, and you are for sure going to incur the wrath of some "Austrian" or "bond vigilante". They will hastily inform you that CPI is manipulated by the government to aid in some evil scheme, that anyone who does groceries - only one out of the several things in the basket - knows that inflation is raging in the USA, and that if the money supply is up, by definition there is inflation, even if actual price of things have not gone up by much.

These fine ladies and gentlemen also often invest in precious metals and dearly hope for a crushing US recession characterized by stagflation. Sadly, they are not about to be right anytime soon.

First, let's see how the backward-looking CPI has done in the USA in recent years.

US Inflation Rate Chart

As anyone who has lived in the USA knows, it has been rather tame. Prices of most manufactured things have gone down as USA has imported deflation from low cost countries.

But what about forward-looking inflation? The best measure of this is the TIPS/Treasury breakeven rate, which is the gap in yield between inflation protected Treasury securities and the regular Treasury securities of the same maturity. This gap is what the market is expecting inflation to be over the maturity period. Let's examine the breakeven rates for the 5-year and the 10-year TIPS/Treasury.

10 Year TIPS/Treasury Breakeven Rate Chart

As the chart above shows, over 5 years the forward-looking inflation is a tame 2.16%. Over 10 years, it is 2.52%, which is curiously matching the upper bound of inflation that the Feds have said they will be comfortable with in order to generate economic growth in the USA. Strange coincidence, indeed. The market moves in mysterious ways.

Anyway, so not only has backward-looking inflation been tame, forward-looking inflation is expected to be tame as well by the market. Just to make one thing clear, this breakeven rate cannot be manipulated. The Treasury yield, for sure, can be pushed down by the Feds through open market activities. But they have nothing to do with TIPS yields, and hence the breakeven rate.

So, it is pretty clear that the market doesn't believe inflation will be an issue in 2013. But what's driving this low level of inflation in the face of massive monetary stimulus by the Feds? What could be the forward-looking indicator? I think it is the share of household disposable income that goes to service debt. This, unfortunately, has been dropping as American households keep deleveraging.

US Household Debt Service as Percent of Disposable Income Chart

So why does deleveraging puts downward pressure on prices? After all, if the households have more money left behind after paying their revolving credit, shouldn't they have more money left to buy goods and services. Alas, it doesn't work like that. The average American consumer is in debt. They take loans to make ends meet. When they actually pay off loans than take on more loans, in aggregate they spend less. When there is less money chasing goods and services, there is little upward pressure on prices. Hence inflation is tame.

So when will households start to borrow and spend like it is 1999 all over again? Beats me, but delay in this is precisely what the Feds are afraid of. The Great Depression changed consumer behavior for a generation. If the current generation or two gets used to paying off debt instead of borrowing and spending, that is surely good for low inflation, but horrible for economic growth. As, when there is low demand, companies don't need too many people to produce goods and services. When companies lay off people, people become even more conservative, and start to take even less debt and spend even less. This gets to a vicious cycle called the liquidity trap. The Feds keep on increasing the money supply, but inflation remains tame as does economic growth.

This is what happened in Japan. The US Fed knows that, so is pumping money like it has a stash of platinum Trillion Dollar coins hidden in its basement. Hopefully, it will succeed. But till the household debt starts to grow again, inflation will likely remain tame. As the chart shows, given the level of the drop it will likely be a while before household debt reaches the historical 13-15% level, very unlikely to happen in 2013. At any rate, inflation always trails household spend anyway. Given that, it is unlikely that we will see a bout of inflation in 2013.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.

Source: Why Inflation Will Remain Tame In 2013