Should We Be Worried About Inflation?

by: James Picerno

The yield on the benchmark Treasury is climbing - again. On Tuesday, the 10-year closed at just under 4.98%, the highest since last August. The immediate cause of the renaissance in the price of money is the growing suspicion that the recession has been postponed, again.

Almost no one's arguing that economic growth's about to explode on the upside, but the latest batch of data suggests that a contraction in GDP isn't imminent either. The most persuasive evidence came in Tuesday's update on the ISM index of non-manufacturing activity, otherwise known as the service sector. Last month, the gauge rose to its highest level since April 2006, reversing March's tumble, and suggesting that growth still has some momentum.

But, along with the upward momentum in business activity comes news that prices are following suit. As David Resler, chief economist with Nomura Securities in New York, wrote in a note to clients on Tuesday, "Non-manufacturing businesses continue to face rising prices as the prices paid index rose to 66.4 in May, the highest since last August (71.9)."

The bubbling of pricing pressure hasn't been lost on the bond market, which now sees fit to err on the side of caution as to what comes next. Adding to the anxiety in pricing money was Tuesday's counsel from Fed Chairman Ben Bernanke on the always delicate matter of inflation. "Although core inflation seems likely to moderate gradually over time," the chairman said in prepared remarks for the International Monetary conference in South Africa, "the risks to this forecast remain to the upside."

The potential for future inflation trouble, in short, isn't quite dead, he warned again.

Meanwhile, Wednesday brought news that the European Central Bank has raised interest rates, again. The Continent's benchmark refinancing rate was elevated to 4.0%, the highest in six years. "This decision was taken," said ECB President Jean-Claude Trichet, "in view of the prevailing upside risks to price stability over the medium term that we have identified through both our economic and monetary analyses."

The ECB, in other words, is worried about inflation, again. "The ECB, like many others, may have underestimated the economic growth dynamic in the euro area," Thorsten Polleit, chief Germany economist at Barclays Capital in Frankfurt, told Bloomberg News on Wednesday. "They will leave the door open for further rate increases by highlighting upside risks to inflation."

There is a certain economic logic to the rising anxiety about pricing pressures generally, according to Wednesday's Wall Street Journal.

"For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation," the paper reported. "Now that damper on prices is beginning to reverse, and global inflation pressure is starting to build."

Chief among the smoking guns cited by the Journal is the fact that,

many countries are operating at close to full capacity, facing shortages of everything from land to equipment. Western workers and their low-cost rivals both are winning higher pay, thanks to rising demand. In some cases, the global links of the economy are increasing costs rather than lowering them, as far-flung businesses compete for the same resources.

According to anther report in the Journal, Dallas Fed President Richard Fisher agrees. He told the paper's Greg Ip that, "I sense that global capacity has moved from being a tailwind to a headwind in terms of inflation control."

It's anyone's guess as to when, or if, the Federal Reserve will opt to hop on the rising-rate wagon. But it's clear that the odds of a rate cut in these United States looked somewhat dimmer on Wednesday as compared to last week. Yet the Fed fund futures market isn't convinced, at least not yet, that higher rates are coming. When I looked at those futures prices early Wednesday morning, the outlook for keeping Fed funds at the current 5.25% remained the dominant view, for the next several months.

But don't let the calm fool you. Indeed, this is no time to take long naps on the beach. Volatility may frighten Mr. Market, but a material shift in sentiment has been known to bring opportunity for strategic-minded investors who keep their cool and have cash at the ready to capitalize on a sudden spike in fear.