Bernanke's Vision of Inflation Reflexivity May Soon Rear Its Ugly Head

Jul.18.07 | About: SPDR S&P (SPY)

One of my favorite indexes, and certainly one of the most important in the world, is the Consumer Price Index [CPI].

It's a thoroughly flawed measure of inflation, as I explained in this Journal of Indexes article in January 2005. But it remains one of the most important indexes in the world, with billions and billions of dollars in government spending tied to it. A new CPI report came out today.

Federal Reserve Chairman Ben Bernanke takes the stand at Congress today to provide his mid-year update on the economy, and he's sure to mention the CPI. With that in mind, I was reading through a few of Bernanke's speeches recently to get a feel for his thoughts on this critical index.

The big issue in the inflation debate right now is whether rising commodity prices reflect a real inflationary threat. The core CPI ignores food and energy as "too volatile," and Bernanke agrees with that decision to a point. But while reading through his March speech to Congress, I came across this interesting little tidbit.

After dismissing the impact of energy prices, he admits that they could have an impact... if we start worrying about them.

Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to be contained.

In other words: See no evil, hear no evil, speak no evil.

Of course, it's pretty hard to ignore a $50 tab at the gas station.

The problem with this assumption is that it presupposes that volatile food and energy commodity prices are mean-reverting. But if you believe in a secular bull market for commodities, a step-wise increase in prices tied to the rapid industrialization of developing markets-prices might not come back down. When and if that idea gains currency, Bernanke's vision of inflation reflexivity could rear its ugly head.