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The New Inflation Problem image

Good Morning. When I entered the financial services business in 1980, inflation at the consumer level (the Consumer Price Index) was running above 14%. The situation was so bad that then-Fed Chairman Paul Volcker had declared war on inflation and was raising interest rates every time you turned around. The problem was that inflation had risen from under 2% in 1965 to nearly 15% in 1980. Thus, the CPI was in an uptrend that did not appear to have an end.

Granted, with the Fed on the warpath, the "inflation problem" did abate in relatively short order and by 1986, the CPI bottomed out at an annual rate of 1.1%. Problem solved, right? Unfortunately though, the 1.1% rate seen in 1986 was the low-water mark for the next fifteen years. And during that span, the CPI oscillated up and down, and was "a problem" several times from the late 1980's through early 1990's. Then just before the credit crisis took hold in 2008, inflation was once again "a problem" as the CPI moved back above 5.5%.

In case you haven't spent a lot of time monitoring FOMC policy, the markets, and inflation over the years, the Fed's target for the CPI is right around 2%. In short, during my 30+ year career, an "inflation problem" occurred when the CPI moved above the 3.0% or so.

However, I'm hearing an awful lot of talk these days about a new kind of inflation problem - as in not enough. That's right, after worrying about the vagaries of runaway inflation for the past 40+ years, the members of the FOMC are now worried that the economy doesn't have enough inflation.

On several occasions we've heard FOMC members talk about this new inflation problem. Heck, just yesterday, St. Louis Fed President James Bullard suggested that the Fed wouldn't make a move until inflation perked up a bit. “The Committee would not normally remove policy accommodation in an environment where inflation is below target and is projected to remain there,” Bullard said.

If this sounds a little off kilter to you, join the club. After all, lots and lots of smart folks continue to fret that the Fed's current ZIRP (zero interest rate policy) and QE programs are sure to spark a serious bout of inflation in the future. And as history has taught us, once inflation starts to roll, it can be tough to stop.

However, Mr. Bernanke appears to be more concerned about the other type of inflation problem - deflation. While the 50-year chart of the CPI only has one brief blip where the annual rate of change was negative (during the credit crisis, the annual rate of change for the CPI went to -2.1%), Gentle Ben appears to remain steadfast in his desire to keep the good ol' USofA out of a Japanese-style deflationary spiral.

Given that the Japanese economy has been plagued by deflation since 1989, Bernanke knows that once deflation sets in it can be even harder to stop than the so-called runaway inflation seen in the U.S. during the 1970's. And if you think about it; he has a point. The Fed has proved that it CAN choke off inflation by hiking rates. However, up until Abenomics was put into effect this year, Japan had tried throwing everything but the kitchen sink at the deflationary spiral, all to no avail. (For the record, Abenomics calls for throwing the kitchen sink, the cabinets, and the counter tops at the problem this time.)

In the old days, you had to read between the lines of whatever the Federal Reserve said (remember the days of the Greenspan "briefcase indicator?"). There weren't statements accompanying rate decisions, press conferences, or the never ending stream of open mic sessions we have today. The Fed Chairman didn't do interviews on "60 Minutes." To be sure, the current Fed is by far the most transparent ever. However, I can't help but believe the lip service being paid to the idea that inflation is currently too low might just turn out to be a smoke screen.

While this may be just one man's opinion, it looks to me that all the talk about inflation being too low is "cover" for the FOMC to continue to pump money into the U.S. economy. You see, up to this point, Mr. Bernanke has erred on the side of caution with regard to economic stimulus. Each and every time Europe's crisis interrupted the fragile recovery, the Bernanke cavalry would mount up and ride to the rescue. So, if I'm reading the tea leaves right (always a risk, btw), my guess is that Mr. Bernanke isn't about to change his stripes at this point in time. Especially now that he knows he will have a new job come next January.

IF (note the use of all capital letters) we continue to hear more talk about inflation being "below the Fed's target" or further discussions of deflation, I would be willing to bet that this would represent justification for the Bernanke Fed to avoid taking their proverbial feet off of the gas pedal too soon. So, IF the data continues to come in mixed AND IF I've got this right, the new inflation problem might mean that the much ballyhooed QE "taper" could begin later than currently expected.

Turning to this morning... Overnight in Japan, politicians put a damper on expectations for a cut in corporate taxes. Such talk has led to weakness in the dollar/strength in the yen, which is not friendly to the yen-carry trade. In response, traders are selling U.S. stock futures this morning. This, combined with another spike higher in interest rates has pressured key technical levels in stock futures and put the bears in charge in the early going. Thus, look for a weak open on Wall Street and for sellers to try and break the current trading range to the downside.

Positions in stocks mentioned: none


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