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Summary

  • Presently, the rate of inflation is running at 0.76% on a non-seasonally adjusted SMSAR basis.
  • We have come out of an inflationary cycle bottom and are in the early stages of rate expansion.
  • Inflation for the year is expected to be between 1% and 2% according to several sources.
  • Weak economic data of late is giving concern that we may enter a deflationary period.

Current State of Inflation

Presently, the rate of inflation is running at 0.76% on a non-seasonally adjusted SMSAR basis.

According to our depth, breadth, volatility metrics, we are in a low state of inflation with moderate diffusion and moderate volatility. This state is an indicator of an expansionary inflation environment.

Based on visual observation of the Coincident Inflation graph, it appears that we are entering the bottom of an inflationary cycle. Couple this with our indication above and we surmise that we are in and are coming out of an inflationary bottom.

Taking a strong look at historical norms for inflation cycles and using them as a comparison, we conclude we are still in the early stages of the inflation cycle.

Utilizing our time series forecast models to forecast the coincident indicator, the forecast is showing volatility through July where the values taper off, demonstrating an overall decline in inflation. The coincident indicator is very good at showing the expected direction of the movement.

Looking at the CPI-U individually with our time series models, the forecast shows a roughly 1% inflation rate over the next 12 months. This model also shows volatility through July, with a taper and increase.

In comparison, Kiplinger states 2014 inflation to be 1.8%, PIMCO 2%, the Survey of Professional Forecasters 1.88%, and Federal Reserve Bank of Cleveland at 1.77%.

Considering our Leading Indicators, they are signaling a sharp decline in inflation on the horizon. Looking at the data in scrutiny, it is unclear if we are presently in the first or last stages of the forecasted decline in inflation. Further economic data will be monitored over the next two months to determine if this is a significant change in trend.

On account of this, the general short term direction of inflation is undetermined and our summation is that inflation will be within 1% to 1.69% for the next 12 months. There is a moderate potential of entering into a deflationary environment and being highly volatile the first half of the year.

Investment Considerations

If correct, interest rates will not rise as rapidly as expected, may come down and TIPS are currently overpriced. If interest rates come down, current bond buyers should make a premium. This premium will be short lived and should be capitalized. With the risk of an inflation drop, I would be looking for a reversal in the trend of the leading inflation indicator before buying any inflation protected securities.

The next update for our forecast will occur around the end of March 2014.

Securities that could be impacted include:

Schwab U.S. TIPs ETF(NYSEARCA:SCHP)
SPDR Barclays TIPS ETF(NYSEARCA:IPE)
iShares TIPS Bond ETF(NYSEARCA:TIP)
PIMCO 1 - 5 Year U.S. TIPS Index Exchange-Traded Fund(NYSEARCA:STPZ)
Vanguard Short-Term Inflation Protected Securities(NASDAQ:VTIP)

Inflation Defined

Inflation is the rate at which the monetary value of a good or services increases.

Movement in the inflation rate is the back drop to movements in real estate, insurance, stocks, bonds, lines of credit, business inventories and investments. Having an accurate grasp of the current and future state of inflation allows the market participant to strategically position themselves to gain, rather than lose, from the movement.

This understanding allows the user to know when to buy and sell financial instruments, how to weight portfolios, when to consolidate or expand debt, when to refinance, and even when to begin aggressive marketing campaigns.

Inflation, or the expectation of inflation, has a real impact on the relationships of short and long-term interest rates. To help understand this, the relationship between short-term and long-term interest rates is known as the term structure of interest rates. When long-term rates are higher than short term rates, we say that the term structure is upward sloping. When short term rates are higher than long term rates, we say that the term structure is downward sloping.

What determines the shape of the structure is based on three components: the Real Rate of Interest, the Rate of Inflation, and the Rate Risk Premium.

The Real Rate of Interest is the rate of return underlying all rates of interest. When the real rate is high, all rates are higher. When the real rate is low, all rates are lower. The Real Rate of Interest can be thought of as a tide that raises or lowers all ships equally. All things being equal, this is the rate of real return the market is demanding.

The Rate of Inflation, and the prospect of future inflation, is dependent on both current inflation and expected inflation derived from the study of historical cycles.

The Rate Risk Premium is the rate that accommodates for the risk associated with longer term debt instruments to account for the risk that the prospective inflation will absorb the real rate of interest.

These three terms can be thought of as a 3 layer cake, with each layer being a portion of realized interest rates on a debt instrument. The intrinsic rates are independent in that they add to each other but also dependent in nature as they interact with each other.

To decompose and forecast these terms, one would gain an understanding of what is driving the markets, and thereby receive insight and strategy.

For the remainder of this report, I will focus directly on the Rate of Inflation. I use the forecasted cyclical volatility of inflation to derive the Rate Risk Premium.

Starting with a base inflation rate, I utilize the CPI-U as my measure of inflation. I decompose the value changes to a rate change over a period basis. With those rates, I create a six month smoothed twelve month trailing average (designated as SMSAR or 6n S 12r respectively) to both eliminate volatility and show the inflation for the last twelve months.

With the SMSAR, I construct Diffusion and Volatility Indexes to form the components of a coincident inflation index. With the coincident inflation index, I decompose the SMSAR into its cyclical components.

With historical cyclical norms, I both establish a reasonable cyclical expectation, and further that expectation by looking at two time series models of the coincident index and CPI-U respectively.

Lastly, I compare this information with a leading inflation indicator to determine if there is a signal of an impending change.

Inflation Depth

The period reviewed for the Consumer Price Index for All Urban Consumers: All Items was from 1/1/1947 to 2/20/2014. For that study period, on a SMSAR basis, the average annual rate was 3.61%, whereas the median rate was 3.09%. The standard deviation was 3.02%, with a range of -4.29% to 19.51%. This is critical information because there are a lot of inflation forecasts produced with a high margin of error. If all a forecast does is tell you that inflation could be above or below current inflation by one standard deviation, it is not a forecast at all but rather a statement of the obvious.

Presently, the rate of inflation is running at 0.76% on a non-seasonally adjusted SMSAR basis.

Using 0.33 multiplied by the standard deviation above and below the median, I then determined three relatively equal in quantity states of either low (I1), moderate (I2), or high (I3) inflation. Presently, we are in a I1 low state of inflation.

The graph "6n S 12r" is shown as follows:

(click to enlarge)

Source: Northwest Trade Research LLC

With this information in hand, I begin to move toward to determine what, if any, are the cyclical components to the data. To accomplish this, I look at two measures, Volatility and Diffusion.

Inflation Diffusion

Diffusion is calculated by looking at the individual difference of 20 components of the CPI minus the overall pace of inflation. Diffusion measures how broad the price increases are in the economy.

The components utilized for this study are Alcoholic Beverages, Apparel, Commodities Less Food and Bev., Communication, Education, Energy, Food, Fuels and Utilities, Household Furnishings, Medical Care Commodities, Medical Care Services, Non-Durables Less Food and Apparel, Personal Care, Private Transportation, Public Transportation, Recreation, Services Less Medical Care Services, Services Less Rent of Shelter, Shelter, and Tobacco and Smoking Products.

Based on these observations, inflation appears to be cyclical in nature indicating that there are periods where inflation is more widespread than not.

To determine a current state in like fashion as the depth (SMSAR rate), and volatility, I utilized a 49 period centered moving average of the median plus or minus the same aforementioned metric standard deviation multiplied by the multiple 0.34. The three different results depending on the total diffusions relationship to the upper and lower limits are either low (D1), moderate (D2), or high (D3) diffusion.

Presently, we are in a D2 moderate state of inflation diffusion.

The graph, "Inflation Diffusion" is shown as follows:

(click to enlarge)

Source: Northwest Trade Research LLC

Inflation Volatility

Volatility is typically a coincident indicator whose objective is to capture the degree of uncertainty associated with an issue.

Generally, the higher the degree of uncertainty is reflective of underlying uncertainty in business activities such as holding business inventories and investor considerations for real returns.

A 12-month moving standard deviation of the CPI-U (on a SMSAR basis) tends to peak near the high in the inflation cycle and trough near the low in the inflation cycle.

Utilizing 0.24 as the multiplier for the standard deviation above and below the median, I determine the upper and lower bounds dividing the data into three equally sized populations.

The three different population samples are either low (V1), moderate (V2) or high (V3) volatility. Presently, we are in a V2 moderate state of inflation volatility.

The graph, "Inflation Volatility" is shown as follows:

(click to enlarge)

Source: Northwest Trade Research LLC

Coincident Inflation Index

We these three measures in hand, I utilize them to construct a Coincident Inflation Index that provides clearer insight into the current condition of inflation. The purpose here is to have multiple measures indicating what state we are in.

The graph, "Coincident Inflation Index," is as follows:

(click to enlarge)

Source: Northwest Trade Research LLC

Based on visual observation of the Coincident Inflation graph, it appears that we are entering the bottom of an inflationary cycle.

With these measures in place, I can begin to take a harder look at the numbers to determine the cyclical components as discussed in the next section.

Inflation Cycles

By comparing the SMSAR and the Coincident Inflation Index to each other, I then can organize the data into cycles using the NBER stage framework. The frame work, briefly described, is based on 9 stages where stages 1 and 5 are the initial trough and cycle peak respectively. Stage 9 is the terminal trough and corresponding initial trough of the next cycle. Each of the stages 1, 5, and 9 are three months in duration with the center month being the determined turning point of the cycle. Historically and updated with the most recent information, the data is as follows:

The median peak to trough duration was 18 months with a standard deviation of 10 months. The total median rate of inflation for the peak to trough periods was 2.64% with a standard deviation of 5.74%. The median trough to peak duration was 23 months with a standard deviation of 15 months. The total median rate of inflation for the trough to peak periods was 7.8% with a standard deviation of 10.44%.

Overall, the total median rate of inflation for each individual cycle was 10.14% with a standard deviation of 17.76%.

Looking at peak to peak relationships, the median peak to peak duration was 46.5 months with a standard deviation of 18 months. For the trough to trough relationships, the median trough to trough duration was 40 months with a standard deviation of 19 months. For the inter-cycle expansion stage relationships, the median stage to stage duration was 7 months with a standard deviation of 5 months. For the inter-cycle contraction stage relationships, the median stage to stage duration was 6 months with a standard deviation of 3 months.

(click to enlarge)

Source: Northwest Trade Research LLC

Inflation Cycle Forecast(s)

History sets the expectation. With that as our theory, the last cycle peak occurred on 6/1/2011. The last cycle trough occurred on 8/1/2013. These dates are subject to adjustment.

Using historical averages to forecast cycle timing, on a average peak to trough basis, the next trough is to occur around 3/30/2013. On an average trough to trough basis, the next trough is to occur around 8/30/2017. On an average trough to peak basis, the next peak is to occur around 12/30/2015. On an average peak to peak basis, the next peak is to occur around 6/30/2015.

Utilizing median durations and median rates as the base assumptions, the following is the projected data for the unfolding of the next cycle based on historical norms:

(click to enlarge)

Source: Northwest Trade Research LLC

Based on this read out, according to historical norms, we are still in the early stages of the inflation cycle.

Inflation Time Series Forecast(s)

Utilizing my time series models, I generated the following forecasts for the Coincident Index, and the CPI-U.

Coincident Index Time Series Forecast

(click to enlarge)

Source: Northwest Trade Research LLC

The forecast is showing volatility through July where the values taper off demonstrating an overall decline in inflation. The coincident indicator is very good at showing the expected direction of the movement. The model has a historical accuracy of 99.85%.

CPI-U Time Series Forecast

(click to enlarge)

Source: Northwest Trade Research LLC

Looking at the CPI-U individually, the forecast shows a roughly 1% inflation rate over the next 12 months. This model also shows volatility through July, with a taper and increase. This particular model has a historical accuracy of 99.80%.

Leading Inflation Index

With this historical benchmark and time series forecasts in place, I then look to other signs for confirmation of where we are in the cycle and what to expect on the horizon.

To do that, I construct leading indicator indicators that show potential signals of what is coming. For inflation, I utilize two indicators, one that signals 6 to 18 months in advance, and one that signals 3 to 5 years in advance. The indicators are comprised of 9 variables, some of which are composite ratios of multiple variables. The variables include capacity utilization, the employment to population ratio, and the trade weighted value of the dollar.

Below is the 6 to 18 month leading indicator. It is showing me that there is a sharp decline in inflation on the horizon. Looking at the data in scrutiny, it is unclear if we are presently in the first or last stages of the decline in inflation.

(click to enlarge)

Source: Northwest Trade Research LLC

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Data Sources

  1. Federal Reserve Bank of New York
  2. Federal Reserve Bank of Cleveland
  3. Federal Reserve Bank of Philadelphia
  4. Board of Governors, Federal Reserve System
  5. National Bureau Economic Research
  6. U.S. Department of Commerce: Census Bureau
  7. U.S. Department of Labor: Bureau of Labor Statistics
Source: Weak Economic Data Signal Low Inflation Ahead