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Ten Observations On Risk of Rising Inflation

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How will we handle the reversal of secular trends that have spanned decades?

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Due to other commitments, I'll probably be posting less often in the next few weeks. However, I don't want to fail to address one of the potential implications of my bullish predictions on growth outlined in my last three articles -- Economic Growth Could Get Scary, Global Trade Data Suggest US Growth Surge, Evidence of Impending US Growth Surge -- that is the potential for an inflation scare.

Aside from the short-term cyclical risks associated with a sharp acceleration of US and global growth, it is my view we are on the verge of important secular shifts in various areas that will profoundly affect inflation dynamics in the next decade.

I'll only outline a few relevant points here which I hope to be able to elaborate on further at a later time.

1. Forget about monetary aggregates. Contrary to popular belief, monetary aggregates are of little to no use for forecasting inflation.

2. If anything, monetary aggregates point to disinflation/deflation. Contrary to popular beliefs, if monetary aggregates were of any use at all, they would currently be suggesting low inflation or deflation. Whether measured by M1, M2, M3, or MZM, the 12-month rate of change in the monetary aggregates have been either growing at a pace well below the average of the past two decades of low inflation, or are outright contracting.

3. Fed actions are not inflationary. Contrary to popular beliefs about Fed "money printing", the actions of the US central bank in the past year have not been inflationary. Virtually all of the Fed's expansion of its balance sheet has been sterilized and therefore poses no inflationary threat in the short- to medium-term. Thus, the inflation risks of the current cycle have almost nothing to do with the recent actions by the Fed.

4. Commodity price risks. The most immediate inflation risk relates to the price of international commodities such as oil, steel, copper, and the like. The Fed, and the US in general, has virtually no control over these global markets. US demand for most commodities, even under an optimistic growth scenario, will be inferior to the overall rate of growth of global supply of these commodities. This means that the US will generally be net drag on global commodity prices on the demand side. The marginal demand growth for commodities is coming from emerging nations, and Asian countries in particular. Very strong economic growth there, combined with very loose monetary policies in those countries, will tend to pressure commodities' prices. Given that demand is relatively inelastic and production capacity is fairly tight relative to current levels of demand in most commodities, strong global growth could provoke major spikes in commodities' prices as demand growth starts to overrun supply growth, and inventories start to shrink appreciably starting in the second quarter of 2010.

Although the US economy has become progressively less commodity intensive over the years, synchronous spikes in commodity prices such as those that occurred in the 2003-2007 period could increase the annual CPI rate by three to five percentage points over any given 12-month stretch. The core CPI could also be affected by 1% to 2% with a lag in such a scenario.

5. Imported inflation. Throughout most of the 1990s and the first half of the 2000s, the US economy enjoyed the benefits of imported deflation, mainly from Asia, but also from Latin America. The devaluation of the currencies of these regions in real terms, combined with extremely strong productivity gains, caused the fundamental equilibrium exchange rate (FEER) of the US Dollar to appreciate to historically high levels. This caused a massive surge of import growth that not only substituted domestic production at lower prices, but prevented domestic producers from being able to raise prices.
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