Peak Theory, Applied To Inflation

by: James Picerno August 22, 2008 | about stocks: TIP    
James Picerno

James Picerno

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print

We've been chatting up the inflation story lately, and for good reason: inflation is rising. But that's yesterday's news. Thus the relevant question: Will it continue to rise?

No one really knows, although everyone has a guess, and those guesses are all over the map, as yesterday's post reminds. On one side are those who expect inflation to remain relatively high, if not rise further. A superficial reading of recent history supports this view, as per the upward momentum in inflation measures of late.

The alternative theory is that inflation will soon fall, courtesy of the economic slowdown. The Federal Reserve subscribes to this theory, and so the central bank remains comfortable with keeping interest rates low. The danger is that inflation's pace doesn't fall, or that it doesn't fall enough to compensate for the low rates.

Not everyone worries about that scenario, and arguably those who do (including your editor) are in the minority. For everyone's sake, let's hope this minority is wrong. On that note, let's consider how the majority thinks. As one example: the latest research from Northern Trust. "If history is a guide, the U.S. economy is probably at the brink of a turning point in inflation," NT's Asha Bangalore writes. "This is entirely conceivable given the projection of weak economic conditions in the near term. Inflation expectations (as measured by the difference in nominal 10-year U.S Treasury note yield and the 10-year TIP yield) as of August 19 stood at 2.15%, down from 2.57% on July 3."

The relevant history is a review of core inflation's behavior as it relates to the business cycles since 1960. "The main conclusion is that both core price measures – core CPI and core personal consumption expenditure price index – peak several months after the peak of the business cycle," Bangalore reports.

By that measure, core inflation is set to peak in the coming months, perhaps before the end of the year. Certainly the Treasury market expects no less, as the inflation forecast via the TIPS market suggests, as per our post yesterday.

The idea that the inflation peak is coming is the last best hope for the optimists that the inflation threat is transitory. The bond market has priced in this future as if it's a foregone conclusion. There is, in short, no room for error in bond prices. And that's what worries us.

We don't doubt that core inflation has a tendency to peak after a business cycle has run its course. Our problem is that the bond market has no doubts that the future will unfold with clockwork precision as it has in the past. Maybe it will, although leaving no room for error in bond prices gives us pause. As we wrote yesterday, expecting headline inflation in the low-2% range for the next 10 years--as per the TIPS forecast--is a bit too optimistic for this skeptic.

Related Articles

This article has 11 comments:

  •  
    Aug 22 02:12 PM
    True "Inflation" (as measured by the pre-Clinton CPI) is currently running ~13%, if not higher.

    www.pcasd.com/the_impa...
    www.shadowstats.com/al...

    Despite all protests to the contrary the Fed does not "care" about high inflation or negative real interest rates. In fact, it's job is to *ensure* negative real interest rates right now, so that Wall Street's well connected speculators can be bailed out. Monetize bigwig losses using Main Street's CDs, MMs and savings accounts --while commodities go through the roof-- is the Fed's true unspoken mandate.

    Q: How do you know when the Fed Chairman is lying?
    A: His lips are moving.
    Reply | Link to Comment
  •  
    Aug 22 02:18 PM
    Um, yea, I would say 2-3% inflation over the next 10 years is a bit optimistic for this skeptic too.

    It's hard to figure out where to hide when bonds, equities, commodities, real estate, treasuries, and even art/antiques(!) are all overpriced at the same time. I guess one hides in cash, takes their lumps from inflation/devaluation in the meantime, and hopes for a crash in something so that an investment can be made. If only interest rates would rise to near the rate of inflation, this wouldn't be so painful.
    Reply | Link to Comment
  •  
    Aug 22 03:06 PM
    We might also apply the "who benefits by being in Error test?" It seems obvious that the fed finds this assumption beneficial, the bond ghouls will be able to make a good trade, and the politicians who don't want to fight inflation because the economy will tank further (it is possible!). The beneficiaries are numerous and very willing to believe anything that looks feasible, or possible. The Fed obviously has adopted the inflation goes was mantra, and so has the BLS which has moved truth and virtue to prove that inflation is just a passing fear. Me? I believe that we are witnessing a Fed louting of the nations savers (that is the 401k etc) and the final nail in the national coffin. The inflation goes way when demand falls, probably in a depression or something close.
    Reply | Link to Comment
  •  
    Aug 22 03:22 PM
    Im not willing to look 10 years in the future (nor should anyone). Right now we are entering a disinflationary period as shown by real estate , autos , electronics and finally commodities --all tanking. The final spear in the heart of inflation is the dollar heading up.


    The elimination of debt always causes deflation (Japan 1990s and US 1930s). The fed is right.
    Reply | Link to Comment
  •  
    Aug 22 04:12 PM
    Chris B, have the credit markets not been "crashing" enough for you? Spreads have been monotonically increasing (though slowly, hence the quotes). Certainly there are companies you feel are going to survive? Why not park some of that money in corporate debt and earn a healthy interest rate?

    I'll answer that question for you: because you feel like waiting for prices to come down more. Is that accurate?

    Your desire to wait for a crash somewhere is a sign that you think asset prices are going to continue falling. That's a defining characteristic of deflationary times, not inflationary.
    Reply | Link to Comment
  •  
    Aug 22 04:23 PM
    <i>Right now we are entering a disinflationary period as shown by real estate , autos , electronics and finally commodities --all tanking.</i>

    I don't know what alternate universe you're living in CLH, but the price trend for most basic commodities --other than housing-- is *still* way up YoY, despite the recent drawback in oil & precious metals. A 25% cut over a few weeks doesn't erase a 100%+ gain from the rest of the year.
    Reply | Link to Comment
  •  
    Aug 22 04:30 PM
    Some how I have a hard time with the idea that a government sitting on multi-trillion debt is going to allow deflation.
    Reply | Link to Comment
  •  
    Aug 22 04:59 PM
    I agree with otbricki, there is a reason that that government is lieing to us about inflation--because much of its debt service, and entitlement is tied to low expecations for inflation, and low cpi numbers. AS the government takes on the five trillion worth of debt that Fannie and Freddie will cost it in mortgage obligations--effective... doubling national debt--we have a scenario developing where the Fed and Treasury both benefit enormously from inflating some or much of this obligation away.

    Its bias is to growth and inflation for the benefits are immediate and accrue to the government, and the cost is in the future and falls to the people at large.

    Contrary to popular opinion--deflation or disinflation is very easy to prevent (creating credit and money) while preventing inflation is far more difficult. The genie is already out of the bottle--inflation is here for another decade or so.

    Doubtful? Look no further than BRIC countries and emerging markets--globally, inflation is picking up nearly everywhere.
    Reply | Link to Comment
  •  
    Aug 22 05:33 PM
    rigel,

    You're right, a good corporate bond ETF in the 5-6% yield range is sounding better and better. But don't rates have to rise to more historically normal levels at some point? If cash is getting harder and harder to borrow, won't the price of borrowing increase?

    "Your desire to wait for a crash somewhere is a sign that you think asset prices are going to continue falling. That's a defining characteristic of deflationary times, not inflationary. "

    Existing equities and bonds went nowhere in the 70's-early 80's in a period of very high inflation (and some argue because of it). It must have been torture to see treasuries yielding over 10% in the early 80's for those who spent all their money a few years earlier at 5%. Doh! That investment just became worth a lot less!

    The question is, are we repeating 1975 or 1981? If it's '75, then I should hold cash (or short term bonds) and prepare for higher rates and cheaper equities and bonds in the future. If it's '81 then the worst is over and I need to plow into equities at the bottom (and buy Apple computer, I know).
    Reply | Link to Comment
  •  
    Aug 23 08:32 AM
    I am certainly no expert, but earlier this year Warren Buffett said, "Inflation has been in remission and is likely to be more prevalent in the next 10 years" and (regarding the dollar) "If we continue the same policies, we're going to get the same results in the next five or 10 years."
    Reply | Link to Comment
  •  
    Aug 24 08:17 PM
    Boy am I confused, Just retired at age 75 and looking for some fixed income investments. Thought TIP might be a decent place for about 25% of it, how about the other 75%?
    Reply | Link to Comment
More Comments on TIP ยป
Top Rated Comment Streams:

Numbers are net rating-

See all Top 100 »
More by James Picerno

Investment Resources
Money Management
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Bonds
Economy
Dollar/Currencies
Earnings