Friday, April 30, 2010

Is the Fed risking Inflation to continue to support the Recovery?

The Fed said in a recent meeting that, Inflation concerns were benign and that it would keep rates lower for an extended period. Jason Cummins of Brewan Howard Asset Management noted that 50% of the consumer Index was in deflation region. However, I find that a bit contradictory because 60% of the US CPI index has been rising in the last year while the 40% represented by rent/shelter had dragged it down (see the graph later in the post for CPI excl. rent component). Then I saw the US PPI data and that points to what I feel is an oncoming rising inflation cycle. I disagree with Cummins' conclusion while sharing his view on the Fed having real tough policy choices..anyway back to Inflation and the PPI....

Example: US PPI went up unexpectedly in March, rising 0.7% against forecast 0.4% and February’s -0.6%. This translates to over 6% on an annual basis in March 2010. With core CPI rising by nearly 1% YoY, with much of the increase in prices is related to rebound in commodity prices (viz. food and energy), there is a risk that this temporary inflationary surge translates into a more generalized pick up in inflation and inflation expectations. This could have the impact of rising wage and salary costs even as unemployment remains extremely high. Thus the risks for US inflation remain to the upside. (part of this is from marketwatch)

This is where Jim Bianco's take on Inflation becomes very interesting. As mentioned earlier, Bianco correctly says that the 60% basket of the CPI comprising food, gas, utilities etc.. have been on the uptick since the last 3 quarters as commodity prices have rebound.

Whats the bad news?

Well, the other 40% namely rent/shelter was kept low through Government tax credits for housing causing rental demand to slow down. With this measure expiring today, the demand for rentals will move upward. Thus the 2.3% figure quoted by Bernanke is at best incorrect. The US CPI should move into the 3% territory around end June 2010 as the effect of the tax credit begins to die out.

This only leads to one conclusion...

The Fed is risking higher inflation to sustain growth (The Fed or any central bank has one basic question in front of it always: do i foster growth ot stabilize prices?). The Fed is soon going to face the fact that the above objectives will go in the opposite direction shortly. The policy dilemma seems to go the way of low rates atleast till December 2010.

In my opinion, We might see a hike in the fed funds rate in Jan or Feb 2011. But if you see my tail-piece below, you may realize why the Fed is in a tight spot..

My conclusion is also connected to three other elephants in the room: soaring deficits, looming bond bubble and potential damper of Fed action on equity markets. Each deserve a separate post.

Tail Piece:
(Policy is also complicated due to the amount of long-term mortgages held by the Fed. A rate hike might end up undoing the Fed's efforts to help banks...we will see that in another post)

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