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Inflation’s outlook runs hot or cold, depending on the prevailing economic and monetary temperature. As an historical matter, however, the trend is clear.

Inflation’s bite into equity returns over time is deep, cutting the S&P 500’s annualized total return to a real 7.2 percent from a nominal 10.4 percent for the 81 years through 2006, according to Ibbotson Associates. Bonds fared even worse, with intermediate term Treasuries reduced to an annualized 2.2 percent real total return from 5.3 percent nominal.

The good news is that yesteryear’s inflation tax isn’t written in stone. Over shorter spans, pricing pressures ebb and flow, implying that investment strategists should periodically review inflation assumptions. On that score, the appraisals have been encouraging lately. The Federal Reserve’s preferred inflation index—the core measure of personal consumption expenditures (PCE) excluding food and energy—looked tame midway through 2007. Core PCE rose just 1.9 percent for the 12 months through June, the lowest annual pace in more than three years.

The market turmoil this past summer has only strengthened the view that inflation is a receding threat. If the mortgage-linked turbulence that has roiled the capital markets infects the economy, pricing pressures may fade further. But excess liquidity had a hand in creating the mortgage troubles, and so it’s debatable that more liquidity is the solution. In fact, one might wonder what effect all the liquidity will have down the road. Judging by history, perhaps one shouldn’t underestimate inflation’s capacity for causing trouble, just yet.

In the short term, of course, anything’s possible, including hefty injections of credit to the financial system to prevent a system- wide seizure. The Fed’s strategic focus on containing inflation for the longer run has been giving way recently to tactical considerations. When the central bank announced an emergency cut in its discount rate on August 16, for instance, the stock market soared in response, breaking seven straight days of sharp selling driven by liquidity worries. Soon after the Fed news, the animated Wall Street wag Jim Cramer announced in his column, “We’re Saved!”

But that may have been premature. Strategic-minded investors may still wonder what’s in store in 2008 and beyond. Indeed, if the Fed cuts rates to shore up sagging investor confidence for any length of time, the cash infusion will feed into an ample existing supply of liquidity in the global economy, to which the United States is inextricably wedded. The Fed controls the U.S. money supply, but that’s only part of the story in a world where capital flows effortlessly across borders. The higher growth rates for money supply in China, India and other countries may keep liquidity bubbling in these United States for longer than is apparent by looking exclusively at domestic statistics. China, for instance, is a leading trading partner with the U.S., insuring that the 20 percent rise in the Middle Kingdom’s broad money supply impacts liquidity in America, where money supply has been expanding just one-quarter as fast.

In short, today’s apparent triumph in containing prices may come with footnotes. The fine print also includes the fact that headline PCE (which includes food and energy) has been running hotter than core inflation (which excludes prices of food and energy). Headline advanced 2.3 percent for the year through this past June—well above core’s pace. That’s hardly threatening when viewed in the context of headline’s history, although it’s still too early to declare total victory over inflation.

Headline’s rate of ascent looks low in absolute terms, but it’s rising faster than core, which may be an early warning sign that inflation’s potential isn’t yet dead. That’s no sudden trend; headline’s been bubbling for several years, as the chart below shows.

Headline’s lead is troubling because it breaks with the previous trend of roughly comparable rates of change in the longer run between the two inflation measures. For the five years through June 2002, for example, headline PCE climbed at an annualized 1.7 percent, or only slightly faster than core’s 1.6 percent. From 1997 to 2002, headline inflation actually trailed core. In contrast, for the five years through this past June, headline’s edge has been relatively large, running at an annualized 2.6 percent over core’s 2.0 percent.

The reason for the difference: energy prices rising faster than inflation generally. Does the energy bull market imply that the relationship between headline and core has changed? If so, should investors stay wary about future inflation even though core looks tame?

The jury is still out, although the widening difference in headline over core is stoking debate about whether food and energy prices should still be overlooked as inflationary signposts. Populist- minded critics complain that while the Fed prefers core, consumers are stuck with headline. Everyone buys food and energy— regardless of price—and so inflation properly measured for the economy should include those crucial commodities.

By that standard, inflation continues to challenge the average household budget. Energy has been in a bull market in the 21st century, and some analysts reckon that prices will trend higher still for years to come. In contrast to past energy spikes, the current one is driven by a fundamental rise in demand. Supported by accelerating economic development in China, India and emerging markets generally in the 21st century, global energy demand has jumped in kind. Meanwhile, supply growth hasn’t kept pace, particularly among non-OPEC oil producers. Neither factor looks set to diminish any time soon, if ever.

Concentrating on core inflation may be politically awkward, but some academics promote the narrower measure as a purer gauge of pricing trends. Yes, headline inflation has intuitive appeal because it includes consumer staples, but its value is questioned by the Fed and some monetary economists who say that it’s statistically noisy, which renders it suspect as a tool for monetary policy. The reasoning is that food and energy prices are so volatile in the short term that they distort the true inflation trend in the long term.

One implication of the core-is-better line is that a bull market in energy isn’t always an inflationary event. Common wisdom suggests otherwise. The 1970s showed that a steep rise in the price of oil and gasoline can accompany a surge in inflation. For the casual observer, the apparent linkage is damning

But an influential strain of academic research snubs conventional thinking. A 2003 commentary from the Federal Reserve Bank of Cleveland summed up the energy-as-noise philosophy, advising,

Many people mistakenly believe that a sharp rise in the price of energy is necessarily inflationary. They fail to understand that energy prices adjust to the demand and supply of energy, whereas inflation responds to the demand and supply of money.

The counsel will ring familiar to card-carrying monetarists. As Milton Friedman famously observed,

Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.

Of course, the only views that ultimately count are those of the members of the Federal Open Market Committee, the group that adjusts short-term interest rates. The leader of the FOMC is the Fed chairman, currently Ben Bernanke, a former Princeton economics professor with a research trail asserting that higher energy prices aren’t fated to raise inflation or derail economic growth. The reasoning boils down to the belief that a central bank, by way of its monetary policy, is responsible for inflation levels. That leads back to the question: How should inflation be properly measured?

For Bernanke and company, core measures are preferred. One explanation comes from evidence that core does a better job of forecasting headline inflation—even better than headline inflation itself. A number of studies over the years assert no less, including a paper co-authored by Alan Blinder (a former Fed governor and currently a finance professor at Princeton) that was presented at the Fed’s 2005 annual economic symposium in Jackson Hole, Wyo. The “catch” is that even if core is a better predictor two to three years down the road, mortals remain in the dark in the interim.

Core inflation, in other words, will track headline inflation eventually, or so the academics tell us. In the long run, the two indices are defacto one and the same. But the conceit that core is a better index requires a repeat of history in food and energy. In the past, prices for the two commodities cycled between boom and bust. But if commodities—energy in particular—are currently in an emerging markets-driven bull market that will run for years, core’s value as a forecasting tool may weaken.

“Academic research looks at the past rather than future,” opines Axel Merk, portfolio manager of Merck Hard Currency, a mutual fund that seeks protection against an expected fall in the value of the U.S. dollar relative to foreign currencies. That raises the specter of the monetary generals fighting the last war, he says, which he believes is especially risky at this juncture because “we’re facing a different type of environment.”

Stephen Cecchetti, a finance professor at Brandeis and a former FOMC economist, tells Wealth Manager that core inflation’s past value as a tool for predicting headline inflation may be at risk if food and energy are in a secular bull market. Supporting evidence starts with the recent gap between broad and narrow measures of inflation. “Over the past decade, the difference between headline over core has been about a half percentage point [a year], and so that’s a problem.”

Is it time to re-think the value of core for central banking? Some are starting to suggest as much. Riccardo DiCecio, an economist at the St. Louis Fed, warned in the bank’s July 2007 issue of Monetary Trends of a potential for a “disconnect” between core and headline inflation:

It may not be reasonable to conclude that monetary policy has been effective in maintaining price stability by looking solely at a core measure of inflation that excludes sustained oil price increases.