Inflation: Three Factors Clouding the Picture

by: James Picerno

It should come as no surprise to learn that headline inflation continues to creep higher. The Federal Reserve has been aiding and abetting this trend for some time now, as these pages have long suggested.

Thursday's update on consumer prices advises that inflation is now running at a 3.5% annual pace through last month--the highest in over a year. As our chart below suggests, the trend of higher inflation looks like more than a temporary blip. After bottoming out at a 1.3% annual rate in October 2006, pricing pressures have been on the march upward ever since.

111507.GIF

Yes, the core rate of inflation (which the Fed favors as a gauge for monetary policy) looks better, although questions on this front abound too. Stripping out energy and food reveals an annual rate of inflation through last month at 2.1%, unchanged from September. It's unclear if core CPI's sideways behavior of late is a prelude to a fall or a rise. Much depends on what the Fed does in the coming months.

That said, the Fed seems inclined to err on the side of more liquidity these days, and that may be the deciding factor for 2008. Indeed, as we noted on Monday, nominal M2 money supply is rising at a rate well above GDP's nominal pace, a trend supported by the drop in Fed funds since September.

In fact, another rate cut may be coming, or so the futures markets is predicting. As we write this morning, the January '08 Fed funds contract is priced in anticipation that the central bank will cut rates by another 25 basis points when the FOMC meets on December 11.

Nonetheless, no one should assume that forecasting is easy at this juncture. Divining the future is especially complicated at the moment by a number of financial and economic cross currents. To name but a few:

1) The dollar in recent days has staged a mini rebound, prompting some pundits to predict that the battered buck may be due for higher terrain against its paper counterparts. If so, that may give the Fed room for cutting rates without sparking cries of inflation.

2) Oil prices have dropped in recent days. A number of analysts have said (again) that the underlying fundamentals don't support $90-plus oil. If traders agree, and oil continues falling, headline CPI may be due for a fall, thereby giving the Fed more latitude for rate cuts.

3) The expectation that the U.S. economy is slowing is widespread, which may help take the edge off the oil bull market. But while a slowdown seems likely, there's a fair degree of disagreement of how far GDP's pace will fall and how long it will last. In fact, one might wonder if some are too pessimistic when it comes to the economic outlook. Consider a story today from The Wall Street Journal, which reported that its latest survey of economists reflected a sharp drop in GDP for Q4 followed by a rebound in 2008, as a chart from the article (see below) illustrates. If so, what does this imply for inflation? Meanwhile, if reacceleration is coming, can the Fed justify another rate cut? Monetary policy, after all, works with a lag of several quarters if not longer. Today's rate cut, as a result, can cast a long shadow.

111507b.GIF
Source: Wall Street Journal

We don't pretend to have the definitive answer to these and related questions, but this much seems clear: the potential for volatility is alive and kicking. The economy continues to move through a transition period, which makes forecasting particularly vulnerable to fresh data these days. The good news is that volatility is the friend of strategic-minded investors who are of a mind to exploit the opportunity. The price is short-term discomfort relative to what the crowd is thinking.

That leads to our prediction that most if not all of the major asset classes will be hit with volatility spikes in the coming weeks and months as the markets are whipsawed with surprises of one kind or another. For our money, we're increasingly inclined to take advantage of the spikes when it suits our long-term objectives. Lower prices, in short, imply higher expected returns. Everything else is open for debate.