U.S. Inflation Monitor, Part 2: A Broader View

by: Econ Grapher

In the second installment of this two-part article on U.S. inflation (see first part, on CPI and PPI, here), we look at a few other data points -- specifically, commodities, TIPS, and import and export prices. The point of this wider look is to gain a better gauge of where inflation is coming through and to garner any clues as to the traction inflation has. This is important for investors, as inflation has a critical impact on wealth, valuations, and prices. A keen awareness of the key inflation trends can help investors position themselves appropriately to both gain protection as well as profits.

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Starting with commodities, the chart above tracks the rolling annual percent change of the Thomson Reuters-Jefferies CRB Index (a broad commodities index with about a 40% weighting to energy, about 40% to agricultural and softs, and 20% to metals), along with the key CPI and PPI stats. Through most of the period, commodities prices have been a key determinant of inflation -- especially for producer prices.

Of course, there are many dynamics at play; for example, the effect of recession on commodity prices, the effect of commodity prices in causing recessions, etc. But the key point is that with the surge in commodity prices, and continued upward momentum from events as well as fundamentals, it is likely that we will see continued inflationary pressures from commodities.

Looking at another market, the chart below shows the Treasury-TIPS (Treasury Inflation-Protected Securities) spread, or TT spread, illustrating the difference between the standard treasury (nominal) and the TIPS ("real") interest rates. This spread effectively tells you how much inflation is priced into the TIPS, and thus can give some insight into inflation expectations. (Also, if your view on the evolution of inflation was different, you could take a position in TIPS to take advantage of the view.)

In recent times the TT spread has tracked upwards as the reality of high commodity prices sets in.

Moving on, the chart below tracks the course of U.S. export and import prices, with trends similar to that of the CPI, and especially the PPI (with import prices being a key component of producer prices). Export prices are also an interesting data point from the standpoint of global imbalances; for instance, if export prices rise faster than import prices and volumes stay constant, then the trade balance will improve. Another facet is the effect of higher export prices on aggregate demand -- a sort of delayed inflationary force.

But one thing to remember with export and import prices is the link with commodities. While not always perfect, the course of commodity prices tracks very closely with export and import prices. So while this is another data point confirming inflationary trends, it sort of goes back to the underlying trend of rising commodity prices. In effect, export and import prices are a transmission mechanism for commodity price inflation to the broader economy.

So what is the key takeaway? Commodities. The core theme of rising commodity prices is fundamental to the current inflation situation in the U.S. In some sense, the various other indicators are transmission mechanisms for commodity price inflation. Indeed, if commodity prices had not run up the way they have, then the U.S. would still be faced with relatively subdued inflation -- if not a short period of deflation.

So what is the conclusion? Is there inflation or isn't there? The quick answer is yes, but the long answer basically says for now there is commodity price inflation -- paired with rising inflation expectations and a broadening of inflation across the economy through the transmission of commodity price increases.

Of course the counter-argument is that all current inflation in the U.S. is a temporary effect of a cyclical and supply shock-related spike in commodity prices that will dissipate as soon as commodity prices normalize. Add to that the relatively weak (but recovering) aggregate demand situation, and still relatively ample levels of capacity, and ignoring the sea of liquidity from the Fed, and other loose monetary policy arrangements ... and it is possible to foresee a period of sustained deflation.

But for now, rising commodity prices are having a significant effect on U.S. inflation and inflation expectations. So the Fed should be worried -- but then, in terms of tightening policy, it has a lot it can do (e.g. normalize the books by reversing QE, etc.).

But then, how do you use monetary policy to address idiosyncratic factors across the various commodities? That is a key challenge, and like the ECB, the only option is to try and head off the second round effects by pre-emptively tightening.

It's not simple. But for investors the base case is rising inflation, with a slim chance of hyper inflation, and a reasonable chance of a reversion to low inflation, and a plausible chance of deflation.

Graph Data Sources:
Bureau of Labor Statistics
U.S. Federal Reserve

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