Nov 28, 2004

Inflation, the Yield Curve, and the Dollar

From Between the Hedges on November 20.

Originally posted with a chart of CPI and PPI.

Bottom Line: While some measures of inflation have spiked recently, due mainly to the effects of the hurricanes, they are not even to levels seen in 2000. As well, it is highly unlikely the CRB index, the broadest measure of commodity prices, will continue to rise near recent rates. The rise in commodity prices has been the main source of inflation thus far. Unit labor costs, which account for more than 70% of inflation, have remained well-contained.

My Comment to Between the Hedges

Difficult to understand the comparison you make between inflation in 2000 and now. The front end of the U.S. interest rate curve was never below 5.50% in 2000 and now we are at 2%.

Inflation is not a problem but without much higher rates I am not sure why it would peak here like it did in 2000.

His reply.

I am not comparing. I am just stating a fact. Inflation was more of a "problem" then, yet we didn't harp on it incessantly. Modest inflation has historically been good for stocks and that is what we have now. Low interest rates now are telling me disinflation is more of a problem than inflation. The CRB is likely to decline over the next 12 months. Commodity price increases have been the main source of inflation worries.

My follow up thoughts.

I disagree entirely with the idea that people here are worried about inflation. Central banks around the world have learned to tame inflation and there was a risk of deflation last year so I think most people view 2% inflation as a relief. What people are worried about is higher interest rates. That is the only mechanism central banks can use to control inflation. The U.S. economy is more highly levered than at any other point in history and if interest rates move up significantly, from these "accommodative" levels, then it is difficult to see consumer spending and corporate investment being maintained at current levels.

Expecting the trend in inflation to change of its own accord is silly and I trust the Fed's ability and desire to control it. The only issue is where interest rates will be a year from now and if our economy (and the world economy) are prepared for that level of rates.

Gary also raise the point that the yield curve is flattening indicating disinflation. Personally I see the flattening as an anticipation of immediate dollar weakness. During currency events bonds will trade on a price rather than yield basis as the loss to principal overwhelms the gains from interest payments. The currency adjustment punishes all principal equally but a 30 year bond gets to discount the loss over 30 years. A flat curve indicates the currency adjustment is going to come all at once and chop an equal amount off principal at all maturities rather than a steady erosion that inflicts a larger loss on principal payments further in the future.

Page 9 of this paper has a good chart showing the spread inversion of the Brazil IDU bond (2001 maturity) against the spread of the C bond (2014 maturity) back in 1998 (after Russia devalued and the market began to anticipate a Brazilian dollar default and real devaluation). There was also a nice article on Friday which came to a similar conclusion about the message coming from interest rate markets.


  1. Every measure of inflation was decelerating before the hurricanes hit. I expect that trend to resume in the next few months. Long-term inflation averages around 3%. I think it will be less than that next year. Thus, I do not agree with your insinuation that the Fed will raise rates substantially from current levels given their focus on price stability. Therefore, the leverage in the system should not be a problem. Better job growth and incomes will trump the modest rise in interest rates I see next year.

  2. My "insinuation" about interest rates is based mainly on recent statements out of Fed officials. Two good examples are:

    "First, monetary policy remains accommodative, even with the rise of 100 basis points in the federal funds rate since late June. The nominal federal funds rate is currently 2 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is just above zero--considerably lower than the long-run average of about 2-3/4 percent." - Mark Olson Nov 15th

    "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged his position by now, obviously, is desirous of losing money," - Alan Greenspan Nov 19th

    IMHO Fed officials are only so blunt when they feel the market's expectations are out of line. My best guess here is that they are heading for a 1% real rate for Fed Funds but that may still be too low with the dollars continuing slide in the face of recent higher yields.