Is the CPI a True Indication of What Lies Ahead for the U.S. Economy?

by: James Picerno

Today's report on July consumer prices gives the Federal Reserve a bit more elbow room for lowering rates. This alone doesn't insure a rate cut's imminent, but at least one can reason that the CPI news alone doesn't preclude the central bank from unleashing a fresh round of monetary easing.

The Labor Department reported that seasonally adjusted headline CPI rose by a mere 0.1% last month. For the year to July, CPI climbed by just 2.4%, which is the slowest annual pace since February.

The Core CPI also looks contained. On an annual basis, the CPI ex-food and energy advanced 2.2% for the year through July, which is unchanged from the annual rate posted in June.

On its face, the CPI news comes just in time to counter Tuesday's whiff of trouble embedded in the report on producer prices. As we wrote on Tuesday, there was reason to worry that core PPI was starting to look robust once more. But with no corroborating evidence in today's CPI, one can breathe a sigh of relief. Taken together, PPI and CPI offer a mostly encouraging review about general price trends.

But for those who look beyond inflation measures proper, there are still gads of liquidity in the global economy. This despite the recent liquidity crunch roiling the mortgage market at the moment. The question for strategic-minded investors is whether to take the CPI report as gospel and dismiss the still-robust growth in liquidity in countries near and far. Alternatively, is there reason to fear that global liquidity presents a threat for the Fed and its mandate to keep inflation contained? If so, does that mean that Bernanke and company have less room to ease rates than the CPI report alone suggests?

For some perspective, the current issue of The Economist details the extent of the global liquidity in an article, accompanied by a graphic illustration of the trend, which we reproduce below. The essence of the report is that nominal and real money supply around the world has been growing by leaps and bounds in recent years.

Broad Money Supply Chart
Source: The Economist

The primary source of the currency printing has come from emerging market nations, starting with China. Indeed, The Economist reported that a broad measure of Chinese money supply has risen by 20% over the past year, or about four times as fast as America's. What's more, China's robust money supply growth is far from atypical among developing economies these days. Russia's increase in money supply is racing ahead by more than 50%, based on the past year, while India's expanded by almost 25%.

Overall, emerging market's money supply has climbed by 21% over the past year, The Economist reported, citing numbers from Goldman Sachs (NYSE:GS). Adjusting money supply growth for inflation doesn't temper the trend. Real money supply expansion is advancing at nearly 16% a year, the fastest in decades and far above what seems reasonable given the associated inflation-adjusted GDP growth in the world.

All of this matters for a planet that's hyperlinked through economic, and financial globalization. As a result, the notion that the Federal Reserve alone controls America's liquidity is the stuff of history. True, the Fed is still relevant, and by more than a little, but global forces are increasingly running the monetary show. At the same time, the effects of global liquidity move slowly, glacially. There are no sudden warning bells or fallouts to alert the average observer. But a creeping threat, if that is what the bull market in global liquidity can be called is still a threat and one day its effects will out.

Meanwhile, U.S. investors are consumed with the latest news on the liquidity squeeze du jour. The notion that the world's still awash in liquidity appears to be yesterday's news. Perhaps, but central banks from Beijing to Moscow keep printing currencies at a pace that's unprecedented in recent decades.

The great unknown is how this will impact the U.S. economy in general, and Fed policy in particular in the months and years ahead. We don't know the answer, but we have a few theories. Embracing those theories leads us to believe that maybe, just maybe, today's CPI report may not be all it's cracked up to be as a clue of what's coming.