The Inflation Argument, and other Thoughts

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It is a widely held argument that Government statistics on the economy are bogus. Recent numbers on inflation, for instance, seem like a joke. A 2.4% annual rate of inflation, when the cost of filling up my gas tank has doubled? In addition, the cost of food continues to rise, with shortages reported in grains, rice, soybeans and other staples. The grocery bill certainly has seen better days. Further, you'd be hard-pressed to find any American whose take-home pay has kept up with rising prices. For those unfortunate enough to have a job loss, the damage inflicted by price increases is that much more magnifying.

The fear of course, is a rising spiral of inflationary pressure that forces the Fed's hand to raise rates to outrageous levels (as in the early 1980s) to stamp out runaway inflation. However, there are other sides to the discussion that need to be considered before we throw in the towel.

The Psychology of Inflation

Inflation, stagflation,'s all a mindset. How so? We accept our fate of higher prices because the demand for products is so strong. Only when the specter of higher rates enters into the discussion will the inflation dragon be slain. One hears and reads enough about it...each and every day on the tube, radio, internet ... it becomes a foregone conclusion. Especially on essential items such as gasoline and food. Travel has also become more expensive as airlines adapt to the new environment.

But how does inflation affect the mind? The obsession or attraction to consume for Americans is just too much to overcome. Prices may continue to rise but will likely never affect the spending habits of our citizens. Likewise, other countries have eyed the US as a place to spend their wealth and have adopted the 'shop now, save later' mentality. We see this in China, Brazil, Russia, Eastern Europe and other Asian nations. Consumption fever has driven prices higher as products are swallowed up to sap current inventory.

You see where this is going, don't you? Clearly strong demand will stimulate growth and ramp up production again, creating a new business cycle. And what of price inflation? Input prices [PPI figure] tell us that price increases are likely to stick as long as demand is strong...which it is. Much like the housing crisis, as long as demand is there, prices will rise...until it ends.

The Bond Market is TIPping its Hand

Bonds have sold off pretty severely lately with the 10-year yield crossing the 4.5% mark last week. Since bottoming in March, the yield has risen from 4.12 to the current level, an increase of nearly 10% in yield. Short maturities continue to stay around the 2-2.4% level as the yield curve straightens and normalizes. Is the bond market sanguine on inflation? It appears so, but the rising yield could be trouble.

In the big picture, a rising yield curve is much preferable to a flat one, and the curve is taking shape. So, a selloff in bonds is only going to confirm that there will be good growth ahead with moderate inflation. In fact, TIP spreads have come in quite sharply of late. TIPS are currently down about 3% since the peak in March, pointing toward decreasing inflationary expectations. So, TIPS yields are down yet longer maturities are up? Correct! This augurs well for the growth picture going forward and validates Chairman Bernanke's recent view of lower inflationary expectations into the next cycle.

Market on the Verge of Breaking Out?

Since mid-March the stock market has risen nearly 15%. This is quite a move since that time, as it appeared the market was heading for Armageddon. We're back to the early levels of 2008 right now, and looking to break some stiff resistance.

While the rise has been solid, there are skeptics out there - pundits who are 'certain' the market will correct...and they need it to happen NOW. We all know better than to make those kinds of guesses; rather, we 'listen' and 'watch' what the market is doing. Do we break out or break down? That's not a question that needs answering - how we react to either scenario is the true answer.

The calendar says May, and so far 'sell in May' has been useless. We have a couple more weeks to go, so let's see how things work out.