August 21, 2008
THE PEAK THEORY FOR INFLATION
We've been chatting up the inflation story lately, and for good reason: inflation is rising. But that's yesterday's news. Thus the relevant question: Will it continue to rise?
No one really knows, although everyone has a guess, and those guesses are all over the map, as yesterday's post reminds. On one side are those who expect inflation to remain relatively high, if not rise further. A superficial reading of recent history supports this view, as per the upward momentum in inflation measures of late.
The alternative theory is that inflation will soon fall, courtesy of the economic slowdown. The Federal Reserve subscribes to this theory, and so the central bank remains comfortable with keeping interest rates low. The danger is that inflation's pace doesn't fall, or that it doesn't fall enough to compensate for the low rates.
Not everyone worries about that scenario, and arguably those who do (including your editor) are in the minority. For everyone's sake, let's hope this minority is wrong. On that note, let's consider how the majority thinks. As one example: the latest research from Northern Trust. "If history is a guide, the U.S. economy is probably at the brink of a turning point in inflation," NT's Asha Bangalore writes. "This is entirely conceivable given the projection of weak economic conditions in the near term. Inflation expectations (as measured by the difference in nominal 10-year U.S Treasury note yield and the 10-year TIP yield) as of August 19 stood at 2.15%, down from 2.57% on July 3."
The relevant history is a review of core inflation's behavior as it relates to the business cycles since 1960. "The main conclusion is that both core price measures – core CPI and core personal consumption expenditure price index – peak several months after the peak of the business cycle," Bangalore reports.
By that measure, core inflation is set to peak in the coming months, perhaps before the end of the year. Certainly the Treasury market expects no less, as the inflation forecast via the TIPS market suggests, as per our post yesterday.
The idea that the inflation peak is coming is the last best hope for the optimists that the inflation threat is transitory. The bond market has priced in this future as if it's a forgone conclusion. There is, in short, no room for error in bond prices. And that's what worries us.
We don't doubt that core inflation has a tendency to peak after a business cycle has run its course. Our problem is that the bond market has no doubts that the future will unfold with clockwork precision as it has in the past. Maybe it will, although leaving no room for error in bond prices gives us pause. As we wrote yesterday, expecting headline inflation in the low-2% range for the next 10 years--as per the TIPS forecast--is a bit too optimistic for this skeptic.
Posted by jp at August 21, 2008 9:23 AM
How could you expect inflation go down without BRIC countries' contraction! Even when they are slowing down a little, from 11% to 9% growth for China for example. They are still demanding more stuffs, like more food, coal, oil, metal ...
Posted by: Henry at August 29, 2008 5:21 PM
I am in the minority with the Editor.
My pessimism on the inflation front stems mostly from population trends that will most surely continue to drive up commodity prices. Adding another 3 billion or so people to the planet over the next 30-40 years, along with substantial increases in the middle class populace of emerging countries, will severly tax finite resources. It will take a herculean effort on the engineering front to transform our global, commodity-based economy to one that functions on renewable sources of energy, and on renewable inputs for most of our finished products.
Posted by: Dave at August 21, 2008 2:14 PM