The Inflation Evil That Lurks

Hey, guess what? More mainstream media discovery that Inflation is lurking! Yesterday, it was the NYT, today, the WSJ:

"A specter from the past has been haunting the stock market lately, and,
as with most specters, the question is whether this one is mostly real
or mostly imaginary.

The specter is inflation, and until recently, many investors thought it
was dead and gone. Lately, if you believe the Federal Reserve, it isn’t
exactly ba-a-a-a-ck, but it is lurking. The Fed’s fear of inflation,
together with its clear intention to keep raising U.S. short-term
interest rates to keep inflation in check, is the main thing that has
prevented the much-awaited fourth-quarter stock rally from commencing . . .

A few weeks ago, I gave Professor James Hamilton grief over his 45 year chart of the 12 month change in CPI (1960 – 2005). The very long chart, IMHO, makes inflation look more modest versus its long history than say a 5 year chart would.

Indeed, the impact of any longer term charts is that they make major events look like ripples; You can barely see the 1987 crash on a long SPX chart, and even 9/11 is hard to spot on a 10 year Nasdaq chart.

Today’s WSJ also uses a long term chart — 35 years of CPI and Core CPI.  It presents a case that the core underreports inflation. Note that even during the late 1970s peak of CPI, the Core rate tracked the overall index; In 1972-74, however, the Core lagged the CPI appreciably.

That lag is very analogous to the present BLS reporting, and in my opinion, why the Fed is fighting inflation so aggressively.

Note: I modified the WSJ chart, zooming in on the two periods:<spacer>

click for larger chart

Chart courtesy of WSJ


The entire article is worth reading; I have more excerpts, and the original chart, after the jump.



Specter of Inflation Haunts Dow
While Waiting for Fed’s Fears To Subside, Investors Pull Back, Imperiling an Anticipated Rally

Here’s the original chart before my modifications  version with zooms on the two periods:


Chart courtesy of WSJ

Why is this so important?

"Inflation is important to stocks because it influences just about every element that moves the stock market up and down.

The biggest impact is on interest rates, as rising inflation forces the
Federal Reserve to push interest rates higher. Higher prices and higher
interest rates boost costs for businesses and consumers alike, holding
back sales and profit.

Inflation also hurts the financial underpinnings of stocks, making them
less attractive, since a big piece of stock gains is eaten up by the
rising cost of living. When inflation hits, investors tend to flee to
alternatives such as real estate, gold, other commodities and
money-market accounts."

I discuss all of these issues this past weekend in The Unpleasant Truth About Inflation.
And yet despite the NYT, the WSJ and my own humble efforts, there is
still a steady drumbeat begging the Fed to bail out their long only
equity positions:

"So far, at least, few see any signs of inflation coming back the way it
did in the 1970s, the last time the U.S. was dealing with sustained
oil-price increases and a long-running foreign war. During that era,
stocks languished. The fear is that the medicine the Fed will
administer — higher interest rates — to prevent a return to those
dark days, would also hurt stocks, though not as severely as in the

I suspect those people who are bemoaning the Fed are "talking their book."

Also amusing:  liumping in Greenie with the great Paul Volcker:

Many analysts believe that the main reason for the long bull market from 1982 to 2000 was the ability of Fed Chairmen Paul Volcker and Alan Greenspan to bring inflation and interest rates under control. Consumer-price inflation went from more than 13% in 1980 to less than 2% in 2002. The yield of the 10-year Treasury note fell from more than 15% in 1981 to just above 3%, a 45-year low, in 2003.  (strikeout added)

One problem for the market now is that those glory days are over. It is impossible for inflation and interest rates to fall that much again — they aren’t high enough. All investors can hope for is that inflation won’t head up again — and that is the problem  today.

Fueled by oil prices, consumer-price inflation hit 4.7% in September, the highest level in 15 years. But excluding oil and food costs, the remaining "core" inflation rate barely budged. Wage increases have remained modest.

Signs of inflation bleeding into the rest of the economy have been few — but enough to make the Fed worry. Real-estate prices remain high, and an influential Fed report released Thursday on business activity in the Philadelphia region showed signs that companies, faced with rising costs, are raising prices.

Because it can take nine to 12 months for an interest-rate increase to affect the economy, the Fed feels compelled to step in at the first whiff of a problem. That leads some investors to grumble that the Fed might be overreacting to a problem that doesn’t yet seem very severe outside the energy world.

Many investors are hoping that, once the Fed shows signs that it is ready to stop raising rates, the stock market will rebound. But some worry that the Fed will raise rates too far, hurting profits, sending stocks into a bear market and creating a recession.

A very good column . . .


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  1. Greg commented on Oct 24

    Comparing CPI readings from the 60’s to present day numbers is apples to Asian pears. More than 50% of the CPI is now hedonically adjusted. In 1965, there were no hedonic adjustments.
    Looking at the details of a few products via BLS links, it’s apparent that there are no adverse hedonic adjustments for (e.g.) electronic hardware items. Adding two VCR heads produces a deflationary adjustment, while eliminating the 800 number and perhaps charging $2 a minute for customer service by phone is ignored (thus not inflationary).
    If LT interest rates rise appreciably, the housing market will slow, and the rate of increase of residential rents will increase. So two years hence, we may see a higher core CPI as measured, while actual inflation may be less at that time. The demand curve for rentals has shifted steadily over the past 15 years, due to the increase in home ownership.
    Up until now, the (diminished, now 30%) portion of households that rents has driven the CPI down. Now that 30% may move higher, resulting in an overstatement of the CPI in coming years. This is a rather perverse argument for owning TIPS at current levels (implied CPI of ~2.6% over the next ten years).

  2. Jack K. Miller commented on Oct 24

    OK, inflation is higher than the reported numbers and the FOMC is raising rates higher than many would like. Therefore, the FOMC is evenutally going to come out on top of the curve and long rates will fall even more; then stocks will do well.

    The FOMC pressure is not enough to throw the economy into recession; especially with the current decline in oil having made the switch from a head wind to a tail wind. The drop in energy will level out the CPI and bring it back in line with the core rate.

    The bottom line is that expected inflation is not a deterrent to a good market over the coming months!

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