What's Up With Inflation?

Well, it's not up.

We have had several conversations with clients recently about inflation - or, more specifically, the lack thereof.

Those conversations often have a conspiratorial undertone suggestive of an effort on the part of government officials to hide the true rate of inflation. The implication appears to be that 'they' don't want 'us' to know how bad inflation is getting.

First, let's recount the latest statistics. Two weeks ago we received the latest inflation data. The headline numbers seemed a bit worrisome because they were stronger than recent averages, suggesting that inflationary pressures are on the rise. For most of 2010, reported monthly inflation rates have been around 0.2%. December and January were, however, both 0.4%.

Upon further inspection it is clear that spikes in energy (+2.1%) and food at home (+0.7%) were the outliers that caused the bump in the headline CPI rate. Confirming this is the "core" CPI rate which was up a mere 0.17% in January after a 0.1% reading in December.

We know - "how can you ignore food and energy?!" We are not ignoring them. But, by the same token, we can not ignore rent, hotels, autos, home prices and medical care services, all of which are either in disinflation (falling rates of inflation) our outright deflation (falling prices). Moreover, there is a reason analysts look at both the headline and "core" rates of inflation. Food and energy are notoriously volatile. Spikes in food and/or energy prices have signaled something like 360 of the past two bouts of inflation. (we kid)

Let's talk pricing power. In the latest business outlook survey by the Philadelphia Fed, 60% of respondents said they have held or will hold their price increases to 2% or lower. No sign of pricing power (inflation) there.

Let's talk personal income. Organized labor is famously losing its clout. While layoffs have moderated and payrolls are growing (modestly) again, wage growth has again come to a standstill. February's report (released today) showed no change from January in either hourly wages or the number of hours worked. In fact, unit labor costs have declined for the past six quarters. Without wages rebounding, it is highly unlikely that energy or food price increases will last more than a few months or maybe quarters.

Let's be clear - we respect the risk of inflation and have indeed placed hedges in client portfolios in the event of a sudden return of inflation. However, such positions are currently sized only to be "starter" positions to which we will add as we believe the outlook favors doing so.

The Fed is, in fact, actively seeking inflation. But despite pushing the funds rate from 4.5% to 0%, expanding its balance sheet by more than $1.5 TRILLION, boosting US money supply (M2) by $1.2 trillion, US government debt exploding $4.8 trillion higher, and billions of dollars of direct investment into the nation's largest banks, AIG, GM and Chrysler. . . this is where we find ourselves.

Barely eking out positive inflation numbers.