Is Inflation Really Too Low?

Feb.15.11 | About: iShares MSCI (EEM)

The Federal Reserve has stated that inflation is too low. Is that really the case? This week the Consumer Price Index and the Producer Price Index will announce the results for January. You can be confident the number will be closely watched to confirm the stance of the Fed. The current stimulus, in place to buy $600 billion of Treasury bonds, has been under fire since announced last fall. The easy monetary policy has been accused of fueling inflation and stimulating commodity prices. Time will tell, and the argument will drone on as we march forward.

Some economists believe inflation is already higher than the government statistics show, which in turn is slowing growth. Small business and consumers are already experiencing higher input prices, i.e. inflation pressure. The pressure from commodity prices is evident when you pull up to a gasoline pump. The price has risen more than 30% since August. This translates into less discretionary spending for the consumer and higher prices for businesses.

Federal Express (NYSE:FDX) recently revised earnings guidance due to higher fuel costs. They are adding a fuel surcharge to package shipping rates to offset a portion of the rise. Likewise, Kraft (KFT) is revising its outlook relative to higher food costs on revenue and earnings. The cost increases will be passed onto businesses and consumers eventually, if not immediately. The worst case as seen with both Kraft and Federal Express is that it cuts into margins and profit, and in turn, stock prices.

The Producer Price Index is expected to rise by 0.9% in January following a 1.1% increase in December. The core rate (ex energy and food) is expected to rise 0.3% after rising 0.2% in December. Over the trailing twelve months PPI has gained 4% with the core up 1.3%. Similarly, the Consumer Price Index has risen 1.5% with the core rate up 0.8% the last twelve months. The January estimate for CPI is +0.3% and the core at +0.1%. The December CPI was up 0.5% based on a 4.6% rise in energy prices. The rise in energy directly impacted your gasoline, heating oil, and electricity cost. Inflation is here. It is just a matter of how you measure the impact.

There are regions in the world already facing inflation at higher multiples than the U.S. China has raised rates again for the third time to combat inflation growth. India is facing inflation issues as well as geopolitical challenges. Australia has raised rates as well to fend off inflation relative to strong economic growth and low unemployment. In addition, Thailand pushed rates higher to curtail higher prices.

In contrast, the U.S. has been accommodating with the current $600 billion dollar program to buy Treasury bonds. The liquidity has resulted in higher commodity prices and higher stock prices. The primary concern remains, inflation heating up faster than the Fed believes short term. The rising commodity prices could squeeze consumer discretionary income and company profit margins to the point of stalling growth. The 2008 rise in commodities is a good blueprint to watch as this unfolds in 2011.

The commodity prices are feeding the inflation discussion relative to higher food and energy costs. As stated above the calculation for 'core' inflation excluded these rising costs. The global threat to raise interest rates for central banks continues. This adds to the challenges in both developed and developing nations relative to growth. So far, and for the most part, we have been able to digest the increases at the wholesale level [PPI], but eventually the pass through of price increases will happen if commodity prices continue to rise at the current rates.

The emerging markets see the most immediate impact of commodity prices. A look at the emerging markets economic picture shows the pressure on consumers as well as the stock prices. iShares Emerging Market ETF (NYSEARCA:EEM) has dropped nearly 7% over the last two months. The drop has come more from speculation of the impact inflation will have, than seeing the reality of inflation. This is an area to keep on your watch list to track for the longer term outcome.

No one knows the future and we can all speculate based on research the potential impact of rising commodity prices, but for now the best path is put your money where it stands to benefit from the current trends in play. If the inflation impact escalates, money will rotate into the areas sheltered from inflation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.