Wealth Manager

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 intermediateterm
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 rethink 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.”