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Inflation and Fed Policy

Exactly how do you measure inflation? Last week's letter showed how the Bureau of Labor Statistics uses "owners' equivalent rent" to measure the rise in housing costs rather than the actual price. The conclusion is that it certainly smoothes out the volatility of housing prices, and keeps the CPI (Consumer Price Inflation) from violent swings from quarter to quarter, it also yields periods where the CPI both understates and overstates inflation. Today, given the rapid rise in home prices, it understates the actual costs of inflation, especially if you are buying a new home.

Today's letter will start off with some comments from me on the direction of Fed policy and inflation, and then will go to some comments and notes on inflation I got from several distinguished analysts, including Peter Bernstein, Hoisington Management, and Charles and Louis Gave. I offer their comments in full and unedited, and I think you will find them enlightening.

Some Thoughts on Fed Policy

Last year, as the Fed first began to raise rates, I made two observations. If the Fed does what they almost always do, they will raise rates higher and go longer than anyone at the beginning to the cycle believed. Secondly, I suggested that the Fed would like to see a little inflation come back, as well as significantly higher interest rates, before they have to deal with the next recession or slowdown.

I am not saying the Fed was deliberately pursuing the return of inflation. I am suggesting they are not all that disappointed. The overall trend in the world is still one of deflation. We will once again be worrying about deflation in our future.

Recessions are by definition deflationary. If we had experienced a recession last year, when interest rates were low and inflation was lower, we would have been writing about the worries of deflation.

Now, it looks like they are going to get some cushion. Rates are going to get higher than anyone thought and there is a whiff of mild (though I think temporary) inflation. As we will see from several quotes from Fed Governor's this week, 4.25% (or two more rates hikes) seems baked into the pie. And there may be more after that. Let's briefly look at some of those quotes:

US Federal Reserve Governor Donald Kohn said Wednesday at the 2006 Global Economic and Investment Outlook Conference in Pittsburgh that the Fed should keep tightening credit in a measured way to fend off an outbreak of inflation: "A measured firming of policy should forestall added cost and price pressures and keep inflation contained..... We are considerably closer to where policy needs to be than we were sixteen months ago, but we are not yet at a point where we can stop and watch the economy evolve for a while...I see risks on both sides of my expectations that the growth of economic activity will slow modestly on balance over the next year or so, leaving the economy producing at about its sustainable potential, but unless activity slows unexpectedly, and after the rise in retail energy prices, the risks may be skewed a little toward the upside on inflation."

Translation: we are going to keep raising rates at 25 basis points. Count him as an "inflation hawk."

(Pay attention to Kohn. He is a Fed insider and Greenspan crony whom many think Greenspan will recommend to Bush as his replacement. An obscure man named Greenspan was recommended by then Chairman Paul Volcker to Reagan, just in time to deal with the Crash of 87.)

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San Francisco Fed President, Janet Yellen, stated that: "I consider it reasonable to put the current neutral rate in a range of 3.5% to 5.5%." If you split that you would find Fed fund rates at 4.5%. Count her as an inflation hawk.

In fact, almost every speech by a Fed governor of late has been cut from that same cloth. They are intent on raising rates. There are several reasons for that, and I think inflation is not on the top of the list.

First, Greenspan is clearly concerned about a housing bubble. He calls it "targeting asset prices," but the only asset which is of concern is US housing prices.

Secondly, they want to "reload the recession fighting gun." Back in the dark ages, or around five years ago, Fed rates were at 6.25%. When they first started cutting in 2001, no one, including me, thought they would get to 1%. That is very unusual. The Fed would like to get some more "bullets" in their gun, a bullet being a 25 basis point increase in rates. It is just a matter of time until they will need their bullets, and as we saw last time, you may need more than you think.

Third, they are concerned about inflation. But not that much. If they were really concerned, they would have been raising rates at a much faster clip. They would be throwing in a 50 basis point increase very now and then. But in fact, I think they are happy to see a "little" inflation. It gives them cover to keep raising rates for real reasons #1 and #2.

It would not be politically correct to state they intend to stop the increase in housing prices. There would be lynch mobs forming. So "fighting inflation" is a nice cover.

In fact, I think we are just about to peak on the inflation front. Core inflation is well contained. We are watching copper weaken, and it is leading the other metals. Copper is the metal with an economics Ph.D. Oil is beginning to back off. Consumer spending is slowing, much of which can be blamed on energy costs. Gasoline and heating have risen by close to 50% over last year. That means less for the average American to spend. I think that at the least we see an economic slowdown in 2006.

My bet is that by next summer, no one will be talking about inflation. But short term rates could easily be 4.5%, if you take the above statements along with the rest of recent Fed speeches.

The Conference Board announced today that the U.S. leading index decreased 0.7 percent, the coincident index decreased 0.1 percent and the lagging index increased 0.2 percent in September. Dennis Gartman, not normally a bearish soul, points out the one of the more reliable predictors of recession is the ratio of lagging to coincident indicators (A coincident indicator measures changes in the economy as they are taking place and gives you a picture of the current state of the economy.) Quoting Dennis:

"Firstly, regarding the latter, our long standing clients know that we pay a great deal of heed to the ratio of the Coincident to Lagging Indicators for we have long held that it is the best of the indicators regarding future economic activity here in the US. When it turns down, it means it; and when it turns up, it means it also. This ratio turned down (and turned down hard!) several months ago, after spiking higher and after reaching levels that in the past have proven to be of enormous 'resistance.' We note that the Coincident Indicators fell 0.1% in October, while the Laggers rose 0.2%. That obviously has the ratio of the two falling yet again, and in stock/commodity market parlance, that means that the ratio has 'taken out a previous low.' That, we think is ominous for the economy. Add to this the fact that the 'Leaders' have now fallen for three consecutive months in a row, and we have reason to be wary of the future of the US economy:"

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If things do begin to slow down, you could see long rates dip below short term rates, or invert (short term rates higher than long term rates, or an inverted yield curve). Now, I am reading academic studies which suggest that long rates are 1.5% lower than they should be because of foreign central bank buying of US bonds. This is a hard thing to quantify, so if they are right, then the yield curve could invert and it not mean a recession is around the corner. But that is not the way I would want to bet. If we see an inverted yield curve, we need to begin to look for shelter. In any event, such a climate is not going to be a good one for the broad stock market.

The key meeting of the Federal Reserve will be January 31, 2006. It is Greenspan's last meeting as chair, unless he stays on as interim chair until his replacement is confirmed. We would expect rates to rise to 4.25% at that meeting. But what will the statement look like? Will they remove the word "measured?" Will they change their stance? If they do not alter their stance, then that would suggest rates could go a lot higher. Could it go to the top of Yellen's "neutral" zone? Maybe. They are going to continue to raise rates until home prices stop rising.

Fed practice has been to raise rates until the economy does in fact soften. They always seem to go a little too far. We live in interesting times.

Some Comments on Inflation

I received the following comments or articles on inflation this week, and thought it would be instructive to pass them on to you. This first note was sent to me by Peter Bernstein, the dean of economic writers in this country. His accolades are numerous. He wrote one of my favorite all-time books, "Against the Gods - The Story of Risk." ( It is from his June 2004 edition of Economics and Portfolio Strategy Letter.

"Inflation is the single most important economic variable for investment planning and investment stragegy. Paul McCully of PIMCO made this point with high emphasis at a recent AIMR conference, and he is right on.

"The outlook for inflation suffuses decision-making far beyond the world of investing. No financial, business, economic, or policy decision is possible without considering whether prices in the future will be higher by enough to justify taking action today that we would not take if we had a more relaxed view of the future price level. There is a point where inflation cuts into our self-esteem and influences how we feel about our jobs, our bosses, our customers and suppliers, our homes, and our children's future.

"If inflation is that central to the functioning of our system, the metrics by which consumers, business managers, employees, students, and retired people measure inflation are crucial. It follows that the metrics guiding our policymakers are crucial as well.

"We argue here that the Cost of Living Index now in use is flawed. The deflators in the national income accounts - the result of dividing nominal output by the estimates for real output - are better because of their shifting weights. We propose an alternative version of the CPI that tells a revealing story.

What's the matter with the CPI?

"Policymakers are turning increasingly to what is generally known as Core CPI - the total CPI less food and energy. If you read the minutes of the Federal Reserve Open Market Committee, for example, Core CPI is all they talk about. Core CPI is the total less food and energy. Why less food and energy? Because food and energy are so volatile that they muddy the effort to catch the underlying trend. In addition, policymakers can have little influence on prices for food - nature dominates - although energy prices should respond to the same forces as other prices, even if with a lag.

"This is the point at which we take issue. Consumers confront food and energy prices nearly every day of the week. When consumers worry about inflation, food and energy are likely to be at the top of their list, matched perhaps only by the monthly mortgage payments or rent to the landlord. Core CPI may be smoother than the total CPI, but we cannot say much more than that in its favor.

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"The total and the core index are both distorted by the big difference between inflation in the durable goods area and in nondurables and services. Over the past 14 years, total CPI inflation was 2.7% a year. But CPI durables alone increased at an annual rate of only 0.1% - a total price increase of 1.4% since the first quarter of 1990. The durables are where technology makes the big difference. Technology matters so much in durables that the good people at the Bureau of Labor Statistics do not really have a firm handle on how to measure price changes in items like computers, automobiles, or refrigerators. When the new model comes along at about the same price as the old but loaded up with new gadgets of all kinds, is the price really the same or has it fallen? By what they call "hedonic pricing," the authorities calculate that the price has fallen because of "quality improvement" - even if the gadgets are so numerous, and often so complicated, that the buyer will never make full use of them.

"We do not take issue with hedonic pricing, a matter dealt with at length by other commentators. Our concern is the inclusion of prices of durable goods - notably automobiles, computer equipment, furniture, and household appliances - in the measurements of inflation. This distorts the whole purpose of an index designed to reflect how people will respond to such a critically influential force. Everyone buys food, energy, clothing, haircuts, transportation, and housing services continuously. We buy durables on widely separated occasions. What people see and feel as inflation is what they pay for services and nondurables.

Our solution: CPI/DX

"We offer a new form of the CPI dubbed CPI/DX, which includes all of nondurables, all of services, and none of durables. Unlike Core CPI, our index includes food and energy. We have weighted the nondurables versus the services by the levels of nominal spending on each as reported in the GDP data of the National Income Accounts. Over nearly fifty years, the weights have shifted from 45% services and 55% nondurables to nearly 70% services and only 30% nondurables. Services are enormously important.

"The graph below shows the history of the spread between the CPI/DX and total CPI and the spread between CPI/DX and Core CPI, quarterly, since the beginning of 1957. Our index is almost always higher than the conventional measure, reflecting the slower rate of inflation in durables prices over the long term.

"The CPI/DX has been consistently higher than the official index ever since the mid-1980s. Except for 2001:4-2002:2, it has been higher than Core CPI since the end of 1998. More important for our purposes, the signals emitted by the CPI/DX over the past few years are at variance with the more popular measures. Indeed, the experience shows an entirely different view of inflation since the middle of 1999 - a period when the Federal Reserve people were grumbling publicly a good deal of the time about the risks of deflation and running monetary policy accordingly. While the conventional CPI has risen at an annual rate of 2.5% and Core CPI has risen at a 2.1% rate since early 1999, our index has grown at an annual rate of 3.1%. The graph shows the discrepancy has widened significantly over the past two years.


"In the first quarter of this year, our index was up 2.5% from a year ago, the conventional index was up 1.8%, and the Core CPI was up 1.3%. Over the past two years, Core has risen a total of 3.0%, but the CPI/DX is now 6.0% higher than at the beginning of 2002.

Which do you believe has been the proper measure of inflation?

The Consumer Squeeze

And this note from Van Hoisington and Lacy Hunt of Hoisington Asset Management, one of the premier bond management firms in America. If you invest in bonds, you think a lot about inflation. Here are their thoughts:

"The housing sector's critical role in sustaining consumer spending is also illustrated by contrasting the growth in real disposable personal income (DPI) with real Personal Consumption Expenditures (PCE). Over the last twelve months, real PCE gained 3.5% while real DPI was up a slim 1.4%. Housing equity cash "takeouts" played an important role in closing this gap. The main factor suppressing DPI has been a severe squeeze on wage earners. In the past twelve months, average real weekly earnings declined 1.1% as nominal wages trailed inflation. Without a continuing fresh supply of funds from the housing sector, consumer spending growth could slow precipitously.

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"Responding to Fed rate actions, the household debt service ratio was an unparalleled 13.6% in the second quarter, 1.3% greater than the old mark set three years ago. Short-term interest rates have increased since spring, so debt burdens are destined to climb, and the current record high readings of credit card delinquencies and bankruptcies may soon be broken.

"The consumer must also confront bulging energy prices. In August, total consumer fuel expenditures were 9.1% of total wage and salary income, a level not seen in nineteen years. Total fuel expenditures now total $527 billion versus $298 billion in February of 2002. Relative to wage and salary income, consumer fuel expenditures have advanced 3.1% from the 6% low of 2002. This change is larger than all previous oil hikes including the Arab oil embargo of 1973-74 and the embargo of the late 1970s with the fall of the Shah of Iran and the Soviet Union invasion of Afghanistan. Prior to the Arab oil embargo, the U.S. imported about 33% of its oil, versus over 70% currently (Chart 6). Over time, the pattern of consumer energy purchases being recycled into the domestic economy has been dramatically curtailed, leaving higher energy prices today a dead weight on the economy.

Core Inflation and Bond Market Prospects

In the past year, the price of crude oil ballooned 53% and the price for natural gas more than doubled, so the headline CPI inflation rate could soon exceed 4%. Yet, the more stable gauges of inflation have been flat in 2005. In the twelve months ended August, the core PCE deflator rose 2%, versus 2.2% for 2004. The figure for the market based core PCE was just 1.7%--identical to 2004.

Two of the persistent traits in the U.S. for more than a decade have been fast enhancement of worker productivity and cost containment in the corporate sector. Productivity in the nonfinancial sector - the only one where measurements are valid - bounded ahead at an unparalleled 6.4% in the past four quarters. Indeed, the 3.6% pace of the past five years is also without precedent, and considerably above the 2.1% long-term experience.

With labor compensation modest, unit labor costs inched forward a mere 0.4% in the past four quarters, beneath 0.7% in 2004 and a mean 0.8% per annum over the past five years. This suggests that wage push inflation is unlikely. Aided by global circumstances the Fed has done a very effective job of containing swollen energy prices.

The more subdued economic climate likely in 2006, plus continued Fed resolve, indicate that core inflation will move lower over the next year. With the tendency for long term Treasury bond yields to be determined by multi year patterns in inflation, Treasury bonds should continue on their long term path to lower yields.

And from my clever friends at GaveKal (

"On Friday, inflation was once again a hot topic. Indeed, US consumer price inflation rose to a 25-year high of +4.7% YoY in September (expected +4.3% YoY), a significant jump from last month's +3.7% YoY. Meanwhile, our P-Indicator has recently broken out of negative range, hinting at rising price pressures (see chart). So should we be worried about the potential return of inflation?

"We are not. In fact, looking at the latest US CPI number, we find that core consumer inflation (ex food and energy) actually slowed down to a tame +2.0 YoY (expected +2.1%). This compares with the annual core inflation of +2.3% in September of last year. So despite the strong rally of oil prices, it seems we do not have evidence of any second-round effects. As a side note, this point was also recently made by Australian Treasurer Peter Costello, when he stated, after the G20 meeting, that he did not believe the rising oil prices would lead to a significant increase of inflation.

"Another point to be made is that our diffusion index of US CPI is heading markedly lower. We realize that the average CPI is important, but we believe it is equally important to look at the net of sectors that can raise their prices minus the ones that have to cut their prices. So in our diffusion index of CPI components, we simply look at how many sectors (as reported by the statistical offices) have prices above their 12 months moving averages, and how many have prices below their twelve months moving averages. The difference is our diffusion index of the CPI components, and it is clearly weakening.

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"As for the bond market, it doesn't appear to be overly worried about inflation either. Indeed, following the publication of the US CPI numbers on Friday, the benchmark 10-year Treasury note actually rose by 1/16 point, cutting the yield down to 4.45%, down from 4.46% before the report. Indeed, while yields have gained somewhat over the last weeks, they are still below their highs in late March, when the US consumer inflation rate was at +1.7% (vs. 4.7% in September) and oil prices were at US$54/barrel (vs. US$63/barrel today).

"One explanation could be that there remains a massive 'forced buyer' of bonds in the system, whether pension funds with unfunded liabilities, insurance companies preparing for 'Solvency II,' Japanese investors in search of yield, etc... If this is the case, then the message given by the bond market is not that significant. However, given the weakening core US inflation and the rising US$, we choose to not discount the message from the bond markets. In fact, we are very impressed by the bond market's resilience."

Detroit, New York, Birthdays and a Bet

This has been a quick week. I just got back from giving a speech in Denver. What a beautiful day and city. Too bad their airport is almost in Kansas. (For my foreign readers, the good politicians of Denver built their new, very expensive airport a LONG, LONG way from anywhere, way out in the prairie. Anyone who wants to live near the mountains in Denver, which is the reason to live in Denver, then has a long commute to the airport.)

I will be in Detroit in a few weeks for a speech and meetings. I will be speaking at the Value Investing Conference in New York November 15-16. There are some really great speakers and I am excited to be part of it. If you are interested, you can go to and register. My readers can put in the code RVICJM and you will get an extra $100 off the registration price.

My friends and business associates from Altegris Investments will be in New York as well. Jon Sundt (president), Matt Osborne and Dick Pfister from Altegris Investments will be there to meet clients and potential clients. Basically, we help clients develop portfolios of hedge funds, commodity funds and other alternative investments. If you would like to know more about what we do, you can go to and sign up for my free letter on hedge funds that is just for accredited investors (essentially net worth of $1,000,000 or more). If you want to be able to go into specifics about your portfolio with me and Jon, Matt or Dick in New York, you must sign up soon and start a conversation with a representative from Altegris at least 30 days prior to the conference. We will not go into specifics with anyone with whom we have not had a substantive relationship for at least 30 days. Those are the rules and we follow them. (In this regards, I am president and a registered representative of Millennium Wave Securities, LLC, which is a member of the NASD. Please see the specific risk disclosures which follow below as well as those on the website.)

I was in Denmark on my birthday a few weeks ago, so tonight my kids are gathering to do a double celebration of my birthday and my middle son Chad's as well, who is 17 next week. Time does fly. It is always good to get the kids together, and any excuse will do.

And on a final note, I offer this small personal triumph. Paul McCulley and his friend came into town to watch the Dallas Cowboys host the New York Giants. As we were walking to the stadium, Paul asked me what the line was. I told him 3.5 points with Dallas as the favorite. He asked about a small friendly wager. Not sure what small was for Paul, I said that no one takes the points and Dallas, because Dallas fans are so crazy bookies can pad the line. You can make money betting against Dallas. So Paul shot back, saying "Ok, let's make it 20 bucks and I take just 3." So I figure, what the heck, I can donate $20 to Paul's cause. As it turned out, Dallas won on a field goal in overtime by exactly three points, which made the bet a push. Just not losing $20 made me feel a big winner. Hey, and the Cowboys actually won with four turnovers. I had my first chili dogs in years, a few beers and a lot of fun. All in all, not a bad way to start the week.

I hope your week goes as well.

Your working the half-point spread analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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