Is Inflation as Bad as July Numbers?

Today the U.S. Bureau of Labor Statistics (BLS) announced that producer prices (the PPI) rose by a full one percent in July while the core PPI, which strips out food and energy, increased by a more modest, but still excessive 0.5 percent. And yesterday the BLS reported that prices at the consumer level (the CPI) rose 0.5 percent in July. The core CPI, which excludes food and energy prices, rose by only 0.1 percent.

Before you place bets on rapidly rising inflation and Federal Reserve rate hikes as far as the eye can see, take note of several factors. First the July PPI increase followed no change in June and a 0.6 percent decline in May for the PPI. Second the CPI was unchanged in June. So it is not entirely clear that outside of energy, prices are increasing at the rapid pace announced over the past two days.

However, these increases will convince the Fed to more aggressively raise rates in the coming months. There is now a 99 percent likelihood that the Fed will raise rates at their next meeting on September 20. Moreover they will very likely raise rates at their November and December meetings. Lucky for us that there is no meeting in October. It is important to remember that the Fed sometimes gets it wrong as they did when they raised rates in May of 2000 just eight months before the beginning of the recession.

If the economy behaves as I expect it to, these rate hikes will do more harm than good. That is, higher oil prices, higher prices for natural gas and elevated interest rates will slow the economy without the need for Fed action. The debate is really, are the energy price hikes purely demand driven resulting from an expanding economy or are they instead the result of supply factors such as refinery shutdowns? To the extent that they are supply driven, the Fed action will only compound the problem by slowing and already slowing economy.

One of the real signals of the amount of inflation in the economy is the rate of interest on long term instruments such as the 10-year U.S. Treasury Bond. This rate is equal to the real cost of borrowing plus the expected rate of inflation. Today’s rate is 4.275 percent and low by historical standards. Furthermore, the rate has hardly moved over the past year even while oil prices have increased by over 40 percent. The 10-year rate is telling us that investors think that inflation is not a problem. And the gap between the long term rate and the short term rate (set by the Fed), termed the yield curve is plummeting. This simply means that the Fed thinks inflation is a bigger problem than investors think it is. Collectively, investors always get it right.

EPG