Understanding Inflation (And Why a Little Is Good for Equities and the Economy)

by: Jeff Miller

We like to keep our blog agenda aligned with the most important economic and investment problems. Only a heartbeat ago, that was concern about global deflation and crashing earnings. The focus has now shifted, almost seamlessly, to worries about inflation.

The continuing market rally continues. One worry after another is scratched off. The sellers of fear, gold, structured products, and page views are still setting the agenda. Leading the charge is Paul Farrell who calls Fed Chair Bernanke "the most dangerous human on earth." This is pretty bold talk from someone who has scared a million or more investors into missing the rebound in stocks. He reaches so many people that on a reader-weighted basis, his "free" advice is the most expensive on the Internet. But fear sells, so his Bernanke-bashing gets top ratings in popularity.

Farrell is only one example. It is easy to be a demagogue about inflation.

Inflation - the concept, the measurement, and the policy implications -- illustrates the greatest discrepancy between popular perception and economic reality.

Anyone writing truth on inflation must be willing to shrug off the response. Every time I write on this topic a swarm of commenters, none of whom have spent even a day studying actual data, weigh in to tell me that I am wrong. Despite the futility of my task, I offer a few key observations for truth-seeking investors.

  • Some prices are always going up. Do not confuse your personal cost of living with inflation. "When food prices rise or oil prices rise, people are right to feel in some sense worse off, because they are. And if you are tempted to call that "inflation," I understand. But for policy purposes, the distinction between cost of living increases and inflation as a deterioration in the generalized purchasing power of money is critical." David Altig of the Atlanta Fed and Macroblog.
  • While it is easy to be a demogogue on "core rates" there are sound economic reasons for this focus. Briefly put, emphasizing the headline rate is less predictive of general economic trends and can lead central banks to do the wrong thing at the wrong time.
  • Inflation in emerging markets is the responsibility of emerging market countries. The Fed is focused on inflation in the U.S., and the key measures of inflation show that inflation is below the Fed’s target of around 2%. (Calculated Risk -- Certainly not a Bernanke cheerleader)
  • Forget about "biflation." Some complain that Bernanke is not "embracing" the concept that "Everything you already own -- a house, a car, a stock portfolio -- has rapidly declined in value. Everything you actually need to buy -- food, gasoline, medicine, education -- is going up." Al Lewis, a smart guy with great educational credentials is well-positioned to help investors, but he is on the wrong wide of this argument. Why should Bernanke embrace wrongheaded inflation concepts just because they are popular with bloggers and most readers?
  • Ignore the money supply spinmeisters. There is so much disinformation about "printing money" and money supply growth that this will take a separate article. For now, let me just say that money supply growth is normal or below the levels we would expect for economic recovery. It is not at a level that would stimulate inflation.

Choosing Sources

Most of the commentary you read or see on TV reflects a very simplistic viewpoint. The guys slinging slogans about money printing and commodities would be hard-pressed to match wits with Bob McTeer. His style is slower, more polite, and less suited to TV arguments, but it is more profitable for investors. He directly challenges the claim that Fed policy contributes to food inflation abroad.

Investment Implications

Investors who focus on the inflation debate are likely to make a big mistake. Most of the pundits making the erroneous arguments highlighted above are also trying to convince you not to buy stocks.

In fact, a little inflation would be good for the economy and good for equities. Those who have unwisely fought the Fed for the last two years have still not gotten the message. The Fed is determined to get core rates up to 2% or so and take deflation off of the table. If they are too slow to react, it is still a bullish environment for stocks.

The next thing you will see -- and you heard it here first -- is that bearish pundits will cite the very first Fed move, a move toward neutrality, as a signal of tightening policy. This will be incorrect. There is so much economic slack that the Fed can move slowly to restore normal interest rate levels. There is a broad policy range for Bernanke to get it right.

Understanding inflation is now the single biggest challenge for investors. There is a lot at stake.