- Where Is The Inflation Again?

Inflation is always a surprise to policy makers. It sneaks up on them under cover of the CPI formula. And it tends to appear in the same way Shakespeare described other misery, “not as single spies but as battalions’. It has no slow speed, only far too slow, and far too fast. And yet, the Fed still prefers it, and they’re probably right to do so. Because however difficult politically it may be to address, at least we know what will contain it. Deflation on the other hand, is another kind of animal entirely, and we don’t have a lot of tools to slay it.

I think its clear that inflation is creeping up now, and I think it will reveal its ugly head this autumn. Right now it’s percolating up through the gas pumps and produce aisles and finding its way into everything. As trucker’s fill their tanks, it’s spilling a little inflation onto the contents. It’s spread around the factory floor when the power switch is turned on. But the problem is that all of this takes time before it shows up on the Fed’s reports. Sort of like pump priming. All of this can go for quite a while before there is anything coming out the other end.

And the reason they don’t notice it right off is that food and energy are excluded from the numbers that the Fed uses to estimate inflation. This may seem at first like a big mistake, but actually - it's the right way to handle it too. Lots of things can drive food and energy prices. The Mid East crisis for instance is having an affect on oil now. These other causes to price movement make food and energy very volatile, and that in turn makes it tough to incorporate them as a direct input because they'll introduce more error into the policy that includes them, than actual monetary 'effect'.

In other words, if 90% of the change in oil price comes from non-monetary causes, and 10% from monetary causes, if you include it in your estimate, you're making your estimate 'worse' not better. So why doesn't the Fed just include 10% of the price change? Because no one knows precisely what that exact percentage should be, and because it changes so often and by so much that it can't be relied upon. Vast amounts of money, energy, and intellectual horsepower have been set to the task of figuring it all out, but to my knowledge no one has come up with a statistically reliable means yet. And take my word for it - this is not a new problem. Many people would LOVE to solve it because it would mean big money for the person who does. But sometimes the data just doesn't hold a reliable answer.

So the Fed rightly excludes food and energy from the estimate. But the Fed doesnt' want to exclude them entirely. If, for instance, high energy prices are sustained even after the Mid East issues subside, then it’s very likely a monetary cause and the Fed would be interested. So instead of including it as a direct input, they include as it's being added - as a component of other pricing. And that's how I think inflation is about to sneak up on them.

Over the next few months, I think high energy prices are going to compress profit and operating margins, and when coupled with lower government spending, the economy will not keep pace with the hopes of analysts. As those effects are felt, the stock market will have a correction, depressing confidence and reducing spending further. This will also keep rates from rising too rapidly when QE2 is finally ended in June. They’ll rise, but not dramatically. the Fed will correctly interpret that as demonstrating limited expectations for both growth and inflation.

Then, after a hard summer for stock traders, generally lackluster economic growth stats, slightly rising unemployment, and a benchmark inflation number lower than the Fed’s target, the government will find itself fearful that it could be staring into the gaping maw of another potential recession; and this time it will be one that can’t be eternally blamed on George Bush or greedy millionaires.

In those circumstances the Fed will find both the desire and political will for QE3. They’ll announce it around the start of Q4, and implement it in the autumn of 2011 – just in time for the effect of higher oil prices to find their way through the supply chain and manifest itself in the form of an unusually high inflation print. then in the face of rising inflation, a falling dollar, and stagnating economic growth the Fed will find itself with an unusually loose monetary policy in place. So while they pause and ponder and consider their alternatives, commodity prices will soar.

And as usual, it will be a surprise.