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Economy in Brief

Several Indicators Signal U.S. Inflationary Upturn
by Tom Moeller October 7, 2009

Liquidity has long been viewed as having the potential for fueling inflationary problems for an economy. Before that problem actually emerges, several "market-based" indicators help provide a market view of the pricing outlook. While hardly precise, the figures do give a measure of risk. Some view that risk as an outgrowth of how much liquidity there is in the economy, and by all measures, inflationary pressures are set to rise.

So far, the inflationary environment has been tame. Through August, lower oil prices dropped the y/y change in the CPI to -1.4% although recent gains in prices have raised the three-month rate to 4.9%. During that period "core" prices power fell to 1.5% on both a twelve and three-month basis, down from a high of 2.9% during the summer of 2006.

Let's look at five market-based harbingers of future inflation.

First, the dollar is an indicator of a potential inflationary threat in that it raises the prices of imported goods relative to domestically made products. The dollar has been under significant pressure recently as the weak U.S. economy has forced the Federal Reserve to lower interest rates to near-zero from above 5% in 2007. Certainly, recessions abroad have forced rates lower there as well. The declines, however, have been not as large as in the U.S.

Next, gold & commodity prices give signals of potential inflationary threats. They do not feed directly significantly into product prices, but rather they can be a measure of the market's inflationary psychology. To that end, gold recently has jumped to a record $1,040 per ounce, up 14% y/y. Copper prices also have been strong. They have doubled since December while aluminum prices have risen by one-half.

The interest rate yield curve gives yet another reading of inflationary psychology in the credit market. Following inversion as recently as late-2007 the spread has widened to over 300 basis points, though it recently has narrowed slightly. Also providing an indication of inflationary risk is the market for TIPS, or Treasury inflation-protected securities. Recently, that signal has stabilized after a sharp upturn this spring. From the U.S. Federal Reserve, two papers discuss the value of TIPS. One, The TIPS Yield Curve and Inflation Compensation

can be found here while the other, The U.S. Treasury Yield Curve: 1961 to the Present can be found here.

Money supply growth also can fuel inflation, directly through a heightened demand for goods and services, or just through increased liquidity. The Fed raised the growth rate in M2 to nearly 20% in the aftermath of the crash in stock prices last year. Instead of spending, consumers have chosen to lift their savings to a 3-4% rate from one percent early last year. Lately, money growth has been scaled back radically to near zero or less. In tandem, growth in the monetary base has been dropped. Nevertheless, the liquidity provided earlier by the Fed has not been drained.

What is money being used for? A measure of the degree to which money is being spent or that savings are being rebuilt is the velocity of money, i.e., the ratio of GDP to the money supply. Here the message is clear. Recent money creation is being used for personal liquidity rather than spending power. The ratio recently continued its collapse and fell to 8.6 from its high near 10.5 last year. Velocity tends to fall during periods of declining interest rates and the recent decline has been to the lowest level since the recession of 2001.

So far, the pieces of the puzzle suggest a coming problem of rising prices. What could diffuse this problem is a concerted effort by the Fed to rein in the growth of money. That may already have begun as indicated by no growth in M2 since the spring. However, that's only one of the above measures that points to a diminished inflationary threat. Thus, more aggressive action seems warranted. Recent speculation of the Fed delaying an interest rate increase until later next year is not encouraging.

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