Producer Price Inflation Is Not Dead

Take out food and energy prices, and you find that producer prices have been rising at a 3-4% rate all throughout this economic crisis. Lots of headline-making prices have plunged of course, with oil being the big standout. But oil prices have now stopped falling, and commodity prices in general are stabilizing if not rising. That means the two lines in this chart should start converging going forward, with the blue line (year over year changes in the headline PPI) moving higher. Inflation at the producer level is definitely not dead.

This is extremely important to the general economic outlook. Much of the market's fear has come from concern that plunging demand worldwide would set up a generalized deflation that central banks would be powerless to stop. Call it a variant on the "liquidity trap," or an offshoot of Phillips Curve thinking.

In short, the weaker the economy gets, the more convinced the market becomes that inflation is impossible and deflation is the threat. But now we're seeing that, despite demand hitting a major air pocket all over the world, lots of prices are still rising. That means monetary policy is not powerless, deflation risks are much lower than most people realize, and inflation risk in general is being underestimated.

And that in turn means that way too much money is trying to pile into risk-free securities (e.g., T-bills and T-bonds) that are paying very little in the way of interest. TIPS are a much better alternative to Treasuries if you are concerned about preserving principal and avoiding defaults. As for default risk, that has gone down in line with decreased deflation risk (because deflation is a debtor's worst nightmare), so corporate bonds and emerging market bonds look more attractive.

Full disclosure: I am long TIP, HYG and EMD as of this writing.

Comments

[Mad Hedge F...:]

If you believe that imminent and massive Treasury issuance is going to pop the Treasury bond bubble, and that Obama’s reflationary policies are long term inflationary, you have to be looking at Treasury Inflation Protected Securities. TIPS offer investors a US government guaranteed protection against future price hikes by raising the principal in line with the inflation rate. A 3% coupon TIPS facing a 10% inflation rate automatically boosts the face value of your bond from an issue price of 100 to 110, giving you a total return of 13%. You can buy these directly from the US Treasury, or buy the iShares Lehman TIPS Bond Fund (TIP). The best time to buy flood insurance is at the end of a long drought.

Feb 23 06:51 AM

[cynical and...:]

TIPS offer nice coupons right now but to get 2.5% you need to invest for 20 year based on the january 30 auction. To get your money back you have to either wait till maturity or sell them on the open market. However, if interest rates rise, you won't get full value if you sell before maturity.

An interesting, certainly more flexible, and possibly better paying alternative is I-bonds. These savings bonds currently pay only 0.7% plus inflation. But, you can sell them back to the government at full values (less three months interest anytime after 6 months. If you buy I bonds today you will get 5.64% for the next 6 months. You can get your money back in a year and still make more than 2.8%.

Feb 23 07:29 AM

[kelm:]

Shorting bonds is probably a good play. The action lately looks like Treasuries are very skittish. I think the probability of them breaking lower is much greater than any big rally. TIPS have always worried me as they rely on a government computed number which has been altered in the past and can be altered in the future.

Feb 23 10:32 AM

[Conan the B...:]

As long as wages go up, inflation is not dead.

Feb 23 12:07 PM

[E.D.Hart:]

TIPS for inflation protection relies on official government inflation numbers which are not accurate indicators of true inflation. I wouldn't trust the government to issue a bond to protect me from inflation that gov. has created...would you?

A better bet would be some of the MLP's that raise rates at % higher than inflation. Yes, more volatility, but higher returns are baked in. Nothing is risk free, not even TIPS, but I like my chance better with GDX, and MLPs for long term inflation protection.

Feb 23 01:14 PM

[Chris B:]

I'm long both TBT and TIP.

Is that a contradiction - shorting govt bonds and buying govt bonds? No.

When the markets realize that inflation is back, treasuries will plummet (raising TBT 2x the fall in treasuries) and TIPS will have added principal (boosting TIP).

Worst case scenario: Congress rediscovers the hands-off "it'll fix itself" thinking of Herbert Hoover and Andrew Mellon, resulting in more bank failures / zombie banks, weak stimulus spending, and a decade long deflationary Japanese scenario. In that case, long term treasuries could go to near 1% and TBT could lose big. TIP however, will retain residual value, even if the ROI ends up lower than treasuries. The good news is, you can forsee these trends from a mile away by keeping up with the news and sell instantly if political sentiment turns (keep an eye on protectionism). If things continue the way they're going, however, these holdings should return nice yields.

Feb 23 03:38 PM

[Chris B:]

Do you trust government price surveys less than you trust corporate earnings reports? If so, a couple semesters of accounting classes might change your mind. Investing is a decision of trust, regardless of where the information comes from.

While it is hard to verify the earnings of your MLP's, you can easily spot check the validity of inflation numbers at your local Wal-Mart or real estate ads. Read the auditor's statement in your annual report - there's never a guarantee earnings aren't being manipulated or mistated because not even the auditors can make that guarantee.


On Feb 23 01:14 PM E.D.Hart wrote:

> TIPS for inflation protection relies on official government inflation
> numbers which are not accurate indicators of true inflation. I wouldn't
> trust the government to issue a bond to protect me from inflation
> that gov. has created...would you?
>
> A better bet would be some of the MLP's that raise rates at % higher
> than inflation. Yes, more volatility, but higher returns are baked
> in. Nothing is risk free, not even TIPS, but I like my chance better
> with GDX, and MLPs for long term inflation protection.

Feb 23 03:48 PM

[_richard_:]

I find that those who mistrust the CPI don't read much in the way of economics. If they did, they would certainly see that there are difficult choices involved in constructing CPI, and that it is always of choice between compromises. CPI probably does understate cost of living increases for the wealthy, but for the typical, median household, it does a fair job of doing what it's supposed to do--measure inflation.

Feb 23 07:09 PM

[Conan the B...:]

What Inflation are we talking about here?

Headline or Core?

Headline is to be trusted more so than Core.

Core ignores actual inflation. Without food and energy, we would be grubbing on hillsides and in caves.

Feb 24 02:08 AM