Is this really an inflationary environment?

You can't catch an hour on CNBC, read any online message board or even talk to your friend or neighbor without the topic of future inflation coming up. With the Fed's quantitative easing, oil prices flying above 70 and treasuries selling off, it seems initially that the inflation argument is proving to be correct. But Hylland Market Research believes that there is a strong case against inflation in the near future, and that even DEFLATION may be a bigger threat.

To start the discussion I want to show a chart that includes economic data released this morning, and that is the core PPI (m/m) data. The chart is from Forexfactory.com
First, for those unaware of what the PPI (Producer Price Index) is, take a glance at a couple of definitions from Investopedia.com:

"What Does Producer Price Index - PPI Mean?
A family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. PPIs measure price change from the perspective of the seller. "
"The core PPI figure is the main attraction, which is the finished goods index minus the food and energy components, which are removed because of their volatility. The PPI percentage change from the prior period and annual projected rate will be the most printed figure of the release."

Why is today's PPI numbers important? Several reasons...

First, today's reading was -.1%, not a real earth shattering number by itself, but in a time where the word "hyperinflation" is thrown around daily (and has been for the last several months), it shows that inflation may, at the least, not be coming as soon as many think. It is also worth noting the downtrend in PPI. The Fed's policies have been in effect now for quite some time. ..should we not be seeing a tick up in prices if something as bad as "hyperinflation" is so certain in the near future?

But, possibly the best use for the PPI may be using it just as a way to predict the upcoming CPI (Consumer Price Index) numbers which are released tomorrow (Wednesday). If producers are not experiencing increases in prices, it seems consumers will not either. Although that may not always be the case with specific industries and companies, on the whole, it remains true. The consensus forecast by the 'experts' for today's PPI number was .1%, as mentioned before, the actual reported number was -.1%. The forcasted number for tomorrow's CPI is .1% as well....will we see a negative CPI number (even if it is only a fraction of a percent), in this time where people are calling for hyperinflation?

Maybe this is putting too much focus on this month's economic numbers. One could argue that PPI and CPI are too much of a lagging indicator to use. But bottom line is that PPI is in a downtrend (and CPI is projected to be), and hyperinflation does not occur in a downtrend of prices.



Another reason I believe so many are talking up inflation is because of a lack of understanding of exactly what the Federal Reserve is doing. Many call it "printing money", but is that really the case?
An interesting read if you have the time is "More Money: Understanding Recent Changes
in the Monetary Base" by Glavin. It is posted below, and I will discuss what I think is significant within it below as well:

Stlousfed Inflation Gavin

Publish at Scribd or explore others:

The most important chart in the document:
Maybe it is an assumption to think that people believe the Fed has literally been printing money. But how many jokes have we heard about the Fed "running out of ink" or "running the printing presses full tilt"? The truth is, the increase in the money supply has been solely an increase in bank reserves. Where this gets really interesting is when considering why banks are keeping this tremendous amount of money in reserves instead of loaning it out.

First, one has to know that the Federal Reserve actually pays banks to keep money in reserve at a rate relative to the Federal Funds Rate, which today is basically 0%. Today, the federal reserve is paying banks .25% interest to keep that money in reserve. Banks are free to loan out this money, except for keeping a reserve balance of 10% of its deposits. (That may have changed under one of the TARP laws...)

The big question is 'why are banks content with a .25% return on their money when they could be lending it out for much higher rates?'

It seems clear that banks feel that a .25% return on their money is the best strategy right now. This means that the monetary base available for you and I is not expanding, because banks are not lending out this increase of reserves.

This introduces concerns on a more macro level about the health of our economy...but that is for another discussion.

We will not see inflation when banks are hoarding money and not increasing the monetary base.
Where this gets interesting is guessing the Federal Reserve's actions to the Federal Funds Rate as our economy recovers. There is no doubt that if rates are kept at 0% in the time of strong economic recovery (fundamental recovery....not necessarily any market rally like we have seen since March) we will see inflation. But, if the Fed times rate increases correctly, and manages the size of its balance sheet correctly...It seems technically possible to pull this off without entering "hyperinflation". Keep in mind, the Fed "targets" 3% inflation or so...

In case that was not clear, here is a quote from the document:

In theory, the banking
system reduces excess reserves—but only by
expanding loans and the money supply in a way
that increases required reserves by an equivalent
amount. The key is that the Fed will have to drain
reserves when the economy begins to recover if
it is to prevent a rapid acceleration of inflation.
That necessity drives the current discussion of
exit strategies.

It is also necessary to consider the wealth our last stock market crash destroyed, and how much is still being destroyed every month. Taking into account the dramatic drop in the market cap of nearly every company (and the leverage that people were invested at), estimates for the total amount of wealth destroyed in the last year are around 40 trillion dollars....a tremendous amount of money. Gavin's paper shows a 1 trillion dollar increase in bank reserves since the start of the crisis. Even if those reserves are lent out...there is still a net destruction of wealth out there.

Even though the market has rallied of late...this wealth destruction is continuing:
http://finance.yahoo.com/news/1st-quarter-wiped-out-13-apf-15506413.html

1st quarter wiped out $1.3 trillion for Americans
First 3 months of 2009 wiped out $1.3 trillion, driving Americans' net worth to '04 levels

WASHINGTON (AP) -- The brute force of the recession earlier this year turned back the clock on Americans' personal wealth to 2004 and wiped out a staggering $1.3 trillion as home values shrank and investments withered.

Net worth, or the value of assets such as homes, checking accounts and investments minus debts like mortgages and credit cards, declined 2.6 percent in the first three months of the year, the Federal Reserve said Thursday.

Bottom line for this point, until banks start lending we will not see any hyper inflationary environment. Realistically, the Fed will start raising rates and cutting back on their balance sheet as they deem inflation becoming a risk. Look for that before you start buying into inflation plays.

To introduce the final point against inflation, I would like to quote Zero Hedge (zerohedge.blogspot.com) a truly amazing resource for those of you who have not heard of it and do not read it daily.

But what about all the excess cash flooding the system? As has been discussed on numerous occasions, even with the Quantitative Easing cash factored in, we are now in a much worse place from a mortgage interest perspective, and with every incremental increase in far maturity yields, consumers lose additional household value in the form of home equity (if you couldn't sell your half a million dollar house when mortgages were 4.5%, good luck trying to do so at the same price at 5.5%). On the other hand, the stimulus spending focus on infrastructure projects (and an ungodly amount of pork spending) has little hope of creating absolute inflation pressures: rebuilding highways and bridges by retaining minimum wage contractors does nothing to facilitate wage increases, and the unemployment number rising ever higher simply indicates that anyone harboring thought of a raise in this employment-supply glutted environment will be sorely disappointed for a long, long time.

Zero Hedge brings up several great points. The most significant in our opinion being unemployment numbers. Can we technically see hyperinflation in a period of high unemployment? Certainly. However, taking into account current macroeconomic factors, some of which discussed previously here, it does not seem likely.
Currently, we are only seeing unemployment rising.

When we start to see a confirmed (i.e not one single month) downtrend in unemployment, that is when we need to then consider what the Federal Reserve is doing to then justify a new outlook on upcoming inflation (or deflation).


In addition to the economic data highlight above. We have seen the price of gold (once again) creep up towards 1000 an ounce only to fall back to the mid to low 900 area. Although the price of gold is not purely based on inflation... Certainly we would need to see gold break well into the $1000 range before we consider hyperinflation.

Inflation will once again show its head in our economy, that is certain. However Hylland Market Research feels that deflationary pressure is currently much stronger, and will prevail before inflation does.