Cause of inflation and the Federal Reserve's likely eventual response
Comment of the Day

October 18 2012

Commentary by David Fuller

Cause of inflation and the Federal Reserve's likely eventual response

My thanks to a subscriber for this interesting item by Michael Ashton of E-piphany. Here is the conclusion:
In a non-CPI related note, New York Fed President Bill Dudley said today that the Fed won't be "hasty" to pull back easy money: "If we were to see some good news on growth I would not expect us to respond in a hasty manner." This confirms what we already knew - the Fed is willing to risk letting the inflation genie out of the bottle. Now, faster growth is not actually causal of inflation, as I frequently point out, so not responding to growth is ironically the right strategy, but it's important to consider the reasons he gives for this policy. He is not saying that the Fed will not respond to growth because growth is not something they can affect; what he's actually saying is that (since the Fed believes they can affect growth meaningfully) there is a very high hurdle to tightening even if prices accelerate somewhat further as long as growth remains slow.

So in what I think is the most likely case, continued slow growth with rising inflation, the Fed wouldn't likely start to tighten the screws until core inflation was near 3% (and more importantly, until the economists who are modeling inflation as a function of growth decide they're wrong, and stop forecasting a decline from whatever level we are at today). Since there is a significant delay of at least 6 months from Fed action to any effect on prices, this means that core inflation could easily get comfortably above 3% before any Fed action took effect - and, with the amount of money they'd need to withdraw, and the likelihood that they would start timidly, I have no idea how long it would take for them to stop an inflationary process which, at that point, would have considerable momentum.

So, in summary, this will not be the last uptick we see in core inflation.

David Fuller's view Mr Bernanke was appointed to run the Fed because he had spent most of his career studying and writing about how to avoid a destructive deflation of falling production, profits and prices. Veteran subscribers may recall his November 2002 speech: Deflation: Making Sure "It" Doesn't Happen Here, which I have referred to on a number of occasions.

I take Mr Bernanke at his word, believing that he will go on throwing QE infinity at the US economy to ensure that a deflationary spiral is avoided. In this effort his related and stated objectives are a stronger US economy and lower unemployment. Meanwhile, inflationary pressures are slowly building, as you can see from Michael Ashton's graph in the article above.

This is unlikely to recreate the 1970s inflationary cycle, at least not for a long time, because globalisation and technology, robotics included, will remain a moderating influence on wage pressures. However, we are likely to see inflation in the cost of most household expenses, a trend that is already with us. We should also see it in the prices of many assets, not least monetary metals.

Assuming that financial repression in the form of QE eventually ends, we will also see a normalisation of long-dated government bond yields. Fullermoney has often described so-called 'safe haven' bonds as the last remaining bubble. Moreover, the process of normalisation appears to have commenced, albeit very gradually, given slow GDP growth, recession in Europe, lingering pockets of deflation, and of course QE which is not just limited to the US Federal Reserve.

For evidence that long-dated (10-year) government bond yields have commenced a gradual bottoming out and base building phase, have a look at these charts: US 10-Yr Bond Yield (historic, weekly & daily), UK 10-Yr (historic, weekly & daily), EU (German) 10-Yr (historic, weekly & daily). Note the higher reaction lows on daily graphs; these sequences would have to be broken to indicate a somewhat lower phase of base extension, although retests of the lows appear unlikely. Note also the weekly upside key reversals from the lows on the US and EU weekly graphs.

Japan's 10-Yr graphs (historic, weekly & daily) show a different picture and the July low needs to hold, followed by an eventual break above 0.9% to provide clear evidence of base development. Meanwhile, the BoJ is talking about its own version of QE, although I doubt that governor Masaaki Shirakawa is fully on board regarding this policy. However, his term expires next April and he will not be reappointed.

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