The Inflation Monster Is Tame

Despite the quick run up in gasoline prices, the U.S. economy isn’t about to be eaten by the inflation monster.

The inflation rate is important because it has a major influence on Fed policy. If the Fed perceives serious inflation risk, it will tighten monetary policy and slow the economy. If the Fed tightens too soon it will kill off the recovery and increase unemployment.

On the other hand, if inflation is too low, or if there is deflation, the economy will underperform for a whole host of reasons including the return of a liquidity trap and financial institution failures. So, inflation has to be like Goldilocks’ porridge, not too hot, not too cold but just right.

As measured by CPI the economy has had almost no inflation since 2007. However, inflation worriers point to rising commodity prices as evidence that inflation is about to take off faster than the space shuttle goes into orbit.

While many commodity prices are obviously rising they aren’t the only input into the calculation of inflation. As an example, we live in a service based economy and the cost of providing most services just aren’t overly sensitive to changes in commodity prices.

Below are the top 7 reasons inflation isn’t a problem.

1. Even though January’s core CPI increased by 0.2%, more than 1/3rd of CPI’s components dropped in price.

In January, the prices of some items rose while the prices of other items fell. In fact, more than one third of the individual CPI components experienced deflation in January. For inflation to get out of control, almost everything needs to start to rise in price at the same time. It isn’t enough for only select elements of CPI to be rising.

2. Housing costs comprise approximately 1/3rd of CPI and home prices continue their march downward.

Home prices continue to fall and the real estate generally remains in a funk. As long as housing prices are weak, it’s almost a statistical impossibility to have runaway inflation. Given the large overhang of shadow inventory of homes occupied by delinquent and defaulted homeowners, it will be a while before housing costs start to rise at a rate that moves CPI.

3. Labor costs are in a deflationary wage price spiral.

Wages aren’t rising and the newest round of state and local government union busting is the leading edge of a potentially destructive deflationary labor price spiral. Wide spread wage inflation won’t happen as long as labor is under attack and unemployment is stuck at high levels.

4. The Federal Reserve hasn’t debased the currency and isn’t punch drunk from printing too much money.

The broadest measure of money supply, M2, has increased by only 4.2% in the last 12 months which is only a little above the growth in GDP plus embedded inflation. For inflation to take hold money supply needs to rise a lot faster. A good benchmark to identify inflationary monetary policy would be if there is a sustained growth in M2 that is greater than the nominal growth in GDP plus 2%.

The Fed isn’t punch drunk from printing too much money because someone forgot to spike the punch.

5. The price of gold isn’t an inflation indicator; it’s the result of a carry trade that will come to a hard end when interest rates rise.

The gold bugs are in for a rude awaking when the Fed starts to raise interest rates in anticipation of inflation. The gold carry trade will end and metals prices will plummet.

With inflation low and the Fed Funds rate almost 0%, money is close to free and it costs virtually nothing to buy gold with borrowed money. But, when the Federal Funds rate starts to rise there will be a real cost to owning gold and more and more investors will find that those costs outweigh potential gains.

So, gold bugs beware, when short term interest rates rise you will be exterminated. Gold prices have been rising and rising gold prices isn’t a leading indicator of rising interest rates or inflation.

6. Inflation in China isn’t the same thing as inflation in the U.S.

I was surprised to see during Chairman Bernanke’s recent Capital Hill testimony that he needed to explain to a prominent Congressman that we don’t live in China and that Chinese consumer prices aren’t the same thing as American consumer prices. Perhaps a firm understanding of grade school geography should be a prerequisite to comment on inflation.

7. Rising oil prices won’t necessarily push up the general inflation rate.

Rising oil prices because of geo political events have offsetting consequences. While rising oil prices are definitely inflationary, they also act similar to a consumption tax that saps purchasing power out of the economy and reduces demand for other goods and services. Reduced demand for other items typically results in weak pricing power on the part of suppliers and service providers. As a result, it isn’t at all clear whether rising oil prices in response to Mid-east turmoil will be inflationary, neutral or deflationary.

Also, rising oil prices aren’t manifesting themselves in higher prices for other forms of energy. As an example, natural gas prices are generally weak and have decoupled from oil prices. Falling natural gas prices definitely aren’t a signal of inflationary economic growth.

While it is a good bet that sometime in the next few years the Fed will have to deal with rising inflation, now isn’t the time to change monetary policy in an effort to slay the inflation monster.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.