Inflation? What Inflation…

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During the past week there has been plenty of talk about inflation. The labor department released its September data for Producers Price Inflation (PPI) and the Consumer Price Inflation (CPI), which were both tame, as reported..

Wholesale prices tame beyond volatile food, energy 

Wholesale inflation stayed tame last month outside of a sharp rise in food and energy prices. (source)

Inflation not problem for U.S. last month

The index for U.S. consumer prices rose 0.1 percent in September as the annualized rate of core inflation was the lowest in nearly five decades, according to Labor Department data released Friday. (source)

Clearly to Ben Bernanke the headline numbers were enough for him to continue to make his case for more Fed action. In a speech Friday, Oct 15th, in Boston, the chairman persistently pointed to high unemployment and the weight of weak prices as the greatest threat to the economy. Quoting from his speech, “For the first time in many decades [the Fed] had to take seriously the possibility that inflation can be too low as well as too high.” The crux of this speech last week was that if you aren’t expecting us [the Fed] to renew quantitative easing, you should get on board now as the train is leaving the station. So what did the stock markets do last Friday? Nothing! Not exactly the resounding rubber stamp of approval now was it. The market had already gone up for the better part of the last 30 trading days and now no one wants to be the buyer at these levels, why not?

There is a lot going on in the US over the next couple of weeks. The Mid-term elections will be November 2nd and before we will really know how the results affect the balance of Washington power, The Fed will meet on November 3rd in what will be the “show me the money” meeting for QE2. Either of these events can be a catalyst to push markets higher and we all want to be on that ‘train’ should that be the case. However, shouldn’t there be a “what if” somewhere in this discussion?

An article in Investor Business Daily a couple of weeks ago caught my attention with regards to the “what if.” There are some in the Fed that are concerned that rent/shelter costs in the core CPI are distorting underlying inflation levels. The author of the story suggests that if you strip out rent costs from core CPI, underlying inflation is 2%. Close to the upper part of its range since the late 90’s

housing scares the fed cpi

Fed Poised to Act, Citing Deflation, But Data Disagrees, By Jed Graham

If in fact inflation is adjusted for the weakest sector of the economy and core CPI is running at 2%, then I suspect QE2 will be smaller than QE1 to begin with. Even if QE2 is not of massive size as some expect Ben will continue to tell us inflation is tame as long as he feels stimulus is needed to get the growth engines running again.

Probabilities say that “Helicopter Ben” will go through with QE2 and deliver on his speech from last week. My concern for capital today though is that it’s quite possible the market has already discounted this event and anything short of opening the money printing flood gates is going to be met with a market selloff. I remain somewhat cautious with capital available for investment at least until the ‘what if’ has been removed.

Should the Fed Chairman actually embark on the second round of QE in the coming weeks it will be a clear indication that inflation is not nearly enough to keep the economy moving forward in this environment. Some say that the size of the QE will determine whether it will be meaningful or not, maybe to Main Street it will, but for Wall Street size won’t matter one bit, all they want to see is some sign of action.

Here's what I think, right or wrong. The Bernanke Fed is known for doing what they say they are going to do; therefore, if Bernanke says he plans QE2.0, then for the sake of my job you better believe he is going to do it. Just look back to March 2009 as the most recent example with QE1. The market has now rallied somewhere near 15% since the first discussions about QE2 and yet there hasn’t been a real clear indication of it actually starting, it’s only natural for market participants to pause.

If you are a fund manager and you are trailing your benchmark at this point you are either taking unwarranted risks to play catch up or you're hoping that the current rally loses its legs and essentially comes back to you.

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About Scott Middleton