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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: mishedlo who wrote (8717)	2/26/2004 1:39:24 PM
From: russwinter	Read Replies (1) \| Respond to of 110194

At least a somewhat in the ball park comment (if understated in my view) on current inflation from a mainstream economist: Brian Holland, who helps manage $4.5 billion at Boyd Watterson Asset Management. Inflation and Monetary Policy . . . The uncertainty about inflation and future interest rate increases presents a material risk in the outlook. Equities and the economy would, do better with rate hikes than with these growing uncertainties. We expect very strong growth and rising (though still mild) inflation expectations in coming months, leading to interest rate hikes. U.S. consumer prices rose a larger-than-expected 0.5% month-over-month in January and 1.9% in the twelve months through January. A 4.7% jump in energy prices provided much of the boost to the overall CPI. Excluding energy and food prices, the core CPI rose 0.2% month-over-month, 1.1% year-over-year, slightly higher than expected. With the dollar weak, we expect price increases to spread gradually into the CPI basket. We disagree with the emphasis on idle capacity, slack, the output gap, cost-push concepts, tradable/non-tradable distinctions, and import/export analyses in anticipating inflation. Inflation is a currency phenomenon. The mechanism for price increases is powerful and market-based, involving arbitrage, replacement cost, and active cross-substitution among goods and services. Many prices are already up substantially. The CPI basket lags, but we think inflation expectations will rise in 2004, helping force interest rates higher. The magnitude of the monetary policy error will take time to comprehend. It is akin to the deflationary error in 2000 when the 6.5% fed funds rate was maintained right up to the recession, contributing to the strong-dollar deflation of 2001. The Bank of England has its interest rate at 4%, with plans to hike. The U.S. maintains a 1% interest rate, yet has a much weaker currency, faster growth, higher inflation, a bigger budget deficit, a bigger government debt-GDP ratio, and, we think, more inflation risk due to dollar weakness. The UK’s CPI rate is at only 1.4% (vs. 1.9% in the U.S.). The Bank of England worries about it rising to 2%, and thinks interest rates at and above 4% are appropriate. The Reserve Bank of Australia’s Deputy Governor recently discussed “neutral” interest rates, concluding that it was probably more than 5% and less that 6.25%. This makes sense given the fast-growth opportunities in the U.S. and Australia. We don’t see the justification for a 1% U.S. interest rate. In recent Humphrey-Hawkins testimony, the Fed seemed to foresee 5% GDP growth, 3% productivity growth, and the possibility of 4% unemployment. This rosy an outlook invites neutral interest rates rather than policy accommodation and, by the way, implies a sharp decline in the budget deficit. Fed Chairman Greenspan has sometimes described his role in terms of risk evaluation and management. It would be a less risky course for the U.S. to raise rates now to test the response of the economy and financial markets. That logic should become clearer in coming months as the economy accelerates. Inflation is already running higher than the CPI data indicate. CPI was not very good at measuring deflation, nor the turning point into inflation. There are many problems with the inflation data which causes it to lag and to deviate substantially from market based inflation indicators. We’ll cite two examples here: 1. A big factor in the government’s inflation estimate is housing costs. To estimate them, the Bureau of Labor Statistics does surveys to measure the rental-equivalent value of owner-occupied homes. Owners’ equivalent rent makes up large 22% of the CPI basket and 28% of the core CPI basket. Residential gas and electricity costs make up another 3.4% of the overall CPI basket (but are excluded from the core basket.) In the twelve months through January, owners-equivalent rent was up only 1.8% year-over-year, the smallest increase on record in this data series, compared with the 5.6% rise in house prices. Whether the 1.8% increase is correct or not, it is likely to rise. 2. An important technical factor in the calculation of core CPI holds it down in times of rapid energy price increases. The Bureau of Labor Statistics assumes that rents fluctuate with energy prices. To estimate core CPI, it backs out natural. The effect is to reduce core CPI when energy are rising (current situation) and vice versa when they fall. This adjustment doesn’t affect the overall CPI since both the adjusted rental price and the energy price are included.