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With the core level of producer prices increasing at a rate lower than consensus estimates, it's hard to imagine that inflation is a problem. The core level of producer prices, and consumer prices in the last report, were lower than consensus estimates. If inflationary pressure is lower than expected levels, then inflation should be expected to remain tame, shouldn't it? Then why is the FOMC so concerned about inflationary pressures going forward?

The concern isn't so much in the core level of producer prices or consumer prices, the concern is in the prices of food and energy. Food and energy make up the non-core components of the consumer price and the producer price indexes. These are extracted on a monthly basis and the result is the core levels of PPI and CPI. On a monthly basis these represent potentially volatile levels, and that's why they are extracted from this data. However, on a longer-term basis this is very important information to use in evaluating inflation.

Over the past seven years, the non-core components of the CPI and PPI have increased at about 37%. Inflationary pressures clearly exist in these non-core components. In the past seven years, the non-core components have increased on average 5.3% per year. From an inflation standpoint, this is an extremely aggressive level of inflation. However, most economists on a month-to-month basis discount the increases in the non-core components. That's a mistake longer term. The non-core components are what we depend on for a day to day living. Every month, regardless of economic environment, we need to spend money on food and energy. If the prices of food and energy are increasing aggressively, then our cost of living increases aggressively too.

The recent concern is about wages. With a low level of unemployment, wage pressures are at the forefront of the Fed's watch list, at least it seemed so during Greenspan's era. However, wage pressures have been tame compared to the prices of the non-core components. During a time when the non-core components increased by 37%, wages only increased by about 18%.

With low levels of unemployment and high levels of liquidity, defined by an increasing money supply, and interest rates which are comparatively low compared to the last few decades, the pressure on prices continues to exist. The non-core components should be paid attention to. The prices of these components are growing at 110% versus wages.

If wage increases start to creep into the economy, the non-core component increases can easily filter over into the core components of the CPI and PPI. Recently, over the last seven years, the more expensive lifestyle has been afforded by higher and higher levels of debt and negative savings, and that has kept non-core prices relatively in control because these higher levels of debt seem to have stemmed a willingness to pay more for other goods and services. However, if added liquidity comes into the hands of the consumer in the form of wage increases then those non-core components could begin to see significant increases as well.

The FOMC's ability to control the risk, however, is constrained. Debt levels have increased almost 50% nationwide in the last seven years to about $50 Trillion, and the impact of an interest rate increase on this debt burden would be much more severe than it would have been just a few years ago.

On average, historically, the average level of the Fed Funds Rates since 1955 has been 5.7%; the Fed funds rate is currently at 5.25%. If the current level of the fed funds rate, simply increased to the normal level of 5.7%, $240 billion would be taken out of the economy. Sure, this would offset wage increases, and hopefully that would also thwart escalating CPI and PPI prices, but that would also put the economy at a severe risk of recession.

Unfortunately for the FOMC governors they face a critical decision about Interest rates if inflationary pressures and wage pressures start to filter into the economy.

The housing market, as we all know would be devastated yet again by an increase in interest rates. But how else do the FOMC control inflation? The answer is money supply. Money supply is a measure of liquidity, and the money supply, controlled by the Fed, has been increasing steadily. If the policy decision was to reverse the course of the trend in money supply and start to restrict money instead of ease, inflationary pressures could be controlled without an increase in interest rates. However, in order for that to happen proactive steps need to be taken, not reactive steps. Changes in the money supply do not have the same knee-jerk reaction as an increase in interest rates; they take longer to impact the economy.

Also, stocks in general come under pressure when Interest Rates increase. Specifically Interest Rate sensitive stocks will be hurt. Some examples include banks like Bank of America (NYSE:BAC) and American Express (NYSE:AXP), Home builders like Lennar (NYSE:LEN) and KB Home (NYSE:KBH), lenders like Washington Mutual (NYSE:WM), and dividend paying securities like Reits. All of these stocks will be adversely impacted if Interest Rates begin to increase.

Inflation exists in the non-core components of the CPI and PPI, and inflation is quite high. That's where the Fed is finding its concern. Continued inflationary pressure will fail to moderate if wages start to increase at higher than expected levels. In the meantime, in our opinion, the Fed should begin to tighten money supply because the low level of unemployment is not likely to abate in our opinion. That could alleviate any potential problems that higher Interest Rates may cause, and it could allow the Economy to remain healthy in the face of this risk.

Source: Where's the Inflation? Check the Non-Core Components of the PPI and CPI