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The Federal Reserve governors who are pushing for another round of quantitative easing should take heed because inflation expectations are already rising. After listening to the first round of earnings conference calls, it's clear that CEOs are expecting steady, but slow, economic growth AND higher levels of inflation. This is a problem because once business leaders begin expecting higher levels of inflation, it becomes a self-fulfilling prophecy.

According to a 2005 paper written by Sylvain Leduc, Keith Sill and Tom Stark, "a sudden increase in expected inflation leads to a long-lasting increase in actual inflation via an accommodative monetary policy." Their conclusion makes empiric sense. The oil embargoes in the 1970s created inflationary pressures which weren't reduced until interest rates increased dramatically in 1979 - 1981.

Accompanied by easy monetary policy, businesses and workers expected inflation to keep rising even after initial price shocks moderated. Unlike the oil price shocks of the 1970s, the oil shock caused by the first US-Iraqi war in 1990 didn't lead to sustained inflation because monetary policy was actually tight in the early 1990s.

click to enlarge images

Oil Prices Vs CPI YoY

Source: EIA and Bloomberg

The Fed is already stoking inflationary flames because current monetary policy is already very accommodative. Not only is the Fed Funds rate already at zero, the real yield on TIPS (inflation adjusted bonds) is currently a negative 0.50%.

Despite the already loose monetary policy, the Federal Reserve is expected to try to goose the economy by engaging in another round of quantitiave easing (i.e. printing money to buy treasury bonds or mortgage securities). The theory holds that the United States needs higher growth to reduce the unemployment rate. However, engaging in quantitative easing to improve employment is like trying to hammer a nail with a screwdriver. Any additional monetary stimulus would just create inflation, rather than increase economic demand and reduced unemployment.

Real Interest Rate

Source: Bloomberg

That's because the expectation of inflation is already rising with CEOs and CFOs. And as the United States already experienced in the 1970s, once inflation expectations rise, they become a self-fulfilling prophecy. For example, on the Q3 2011 conference call for Astec (NASDAQ:ASTE) industries, CEO Dr. Don Brock said inflation was a substantial risk. Despite the fact that Astec has seen continued weak demand in the United States for its asphalt and mining equipment, the company is expecting inflation.

"I see a grizzly behind the curtain. If volume picks up, you will see inflation take off," Brock stated on the conference call. The reason being is that inventories and the supply chain is still very lean and order times have stretched out. No business is ordering anything unless they have to. Since no one wants to be caught dead with excess inventory or excess capacity, the first response to increased demand will be price increases.

One week into Q3 earnings season, l have listened to several calls from a broad segment of industries that highlight that volumes in the economy are improving and that inflation pressures are building. Here are just a few of the excerpts:

  • Package Corporation of America (NYSE:PKG):"Wood costs and energy costs are expected to be higher, and recycled costs have begun to trend up and are expected to be higher in the fourth quarter. Containerboard and corrugated products pricing improved significantly year-over-year reflecting a full pass-through of our containerboard price increases to boxes".

  • FedEx (NYSE:FDX): Demand for parcel service remains strong with volumes up 4% year over year. Freight rates will increase an average of 5.9% in 2011.

  • WalMart (NYSE:WMT): Wal-Mart outlined its growth strategy at its most recent analyst day by increasing store counts, adding back reduced inventories and focusing less on pricing. WMT expects food inflation to return in 2011.

  • American (AMR) and Delta (NYSE:DAL): Air traffic and seat miles are up and growing. Revenue growth returning through increase in airfares.

  • Fastenal (NASDAQ:FAST): "The sales to our manufacturing customers stabilized in May 2009 and then started to demonstrate patterns that resemble historical norms. This reversed the negative trend which began in October 2008."

  • W.W. Grainger (NYSE:GWW): Volumes in the United States were up 11%; volumes in Canada were up 24%.

  • Johnson Controls (NYSE:JCI): Automotive backlog is at $4 billion vs $2.5 billion a year ago. North American industry is back to life, the North American OEMs are coming back to their normal sourcing patterns.

  • JP Morgan: Asset management had net inflows of $38 billion and credit card charge offs and delinquencies continue to improve in Cardholder Services.

  • Cognex (NASDAQ:CGNX): Sales expected up 60%. Strong demand for its vision systems, sensors, and identification readers used in manufacturing.

  • Toll Brothers (NYSE:TOL): Actively pursuing growth in attractive land and debt acquisition opportunities. Second consecutive quarter of sequential growth in land position.

The market and businesses, unlike the Federal Reserve, have already been looking into the future and discounting the rising inflationary pressures. Commodities have been surging on increasing demand and a fear of increasing inflationary pressures. The last six month chart of relative performance between stocks and commodities certainly doesn't look like an economy experiencing deflation.

Stocks vs Commodities

Source: Stockcharts.com

The Federal Reserve is undertaking a significant risk by pursuing additional monetary easing on top of already loose monetary policy. Even though consumer prices remain in check according to government reports, inflationary pressures are already building in the pipeline. In the conference calls I've listened to this quarter, CEOs are already preparing for increasing prices. Once inflationary expectations enter the economy, they are virtually impossible to stop without instigating a severe recession.

Source: Expectation of Rising Inflation: A Self-Fulfilling Prophecy