When Low Inflation is High Inflation

Last Friday we got the March reading on inflation as measured by the CPI which came in at 2.7% on a YOY basis.  This was down from the Jan and Feb readings of 2.9% and well below the 2011 clip that ran north of 3% for most of the year.  While this number exceeds the Fed’s 2% implicit target it was welcome news that inflation remains benign.

The Fed’s 2% inflation target seems like a reasonable bogey to shoot for as it strikes a happy medium between what is needed for economic growth while not becoming overly burdensome on household discretionary spending.  The Fed has even toyed with the idea of targeting a higher rate of nominal GDP to close the perceived output gap more quickly that the current run rate.  The growth in nominal GDP required to close the output gap in say 2-3 years would require a annual rate of more like 6% v the current rate of around 4%.  However if the economy is only structurally able to grow at a real rate of 2.0%-2.5% which the Fed would likely agree with, the difference to get you to 6% nominal would be in an uptick in inflation of 3.5%-4.%.  By all accounts the Fed would be comfortable with this higher inflation scenario in order to close the output gap (lower unemployment) because they would view it as “transitory” with the idea that if it got out of hand they could reign in inflation with their monetary tools.

The problem with this logic is that while 3.5%-4.0% is a far cry from the double digit rates experienced in the ’70s and ’80s the inflationary burden on the economy is much greater due to the much lower rate of nominal GDP.  Consider the fact that in 2008 when the Fed started easing aggressively to combat the unwinding in of the credit and real estate bubbles inflation soared as the dollar collapsed and commodity prices spiked across the board.  In the 3rd Q the CPI was registering a 4.9% annual rate.  While this paled in comparison to the 1974 and 1980 spikes that saw 12% and 15% respectively, the ratio in inflation growth rate v the nominal economic growth rate at the time was 2.6x in ’08 v the ’74 ratio of 1.45x and ’80 ratio of 1.8x.  In other words while the top line inflation rate in 2008 was less than half that of the 70s-80s, the burden on top line growth was 50% higher.  That means that despite a much lower “nominal” inflation rate the “real” inflation was actually much higher.  This is what the consumer feels and this is what is likely responsible for falling real wages.

Chart: Bloomberg

(Chart stops at 2008 due to parabolic blow out in negative NGDP v CPI that skews data)

We all know what happened in 2008 with the markets and while most contribute the meltdown to a credit implosion on Wall Street you cannot dismiss the affect of the inflationary spike.  In fact as we have demonstrated in our “Real” Risk Premium metric while the S&P earnings yield will often trade through interest rates, it rarely trades through the CPI, which means the market will not yield less than inflation.  While all the models are calling for using the 10YR yield, it’s actually the inflation rate the market seems to care more about.  Thus we don’t think it was a coincidence that the market crashed in 2011 following an asset reflation correlation and we also don’t think it was a coincidence it recovered when the Fed decided to stop expanding their balance sheet.

Let this be a guide for the balance of the year depending on if the Fed tries to goose the economy with more asset purchases to stimulate inflation and nominal growth or whether they sit tight and let the economy work itself out.

Ironically when everyone is worried about deflation due to a low top line inflation rate and falling asset prices, it’s actually the “real” inflationary burden on a slower pace of top line growth that presents the most risk.


About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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