Thursday, June 29, 2006

The Inflation Conundrum

I’m a two-handed economist today, and the hands are about to come to blows. My “rational economist” hand is waving in the air declaring, “We have every reason to believe that inflation is not an issue over the longer horizon, and only highly risk-averse investors should be buying TIPS.” My “faithful quantitative analyst” hand is pounding the table exclaiming, “The inflation rate is up! Past inflation predicts future inflation! Buy TIPS!!” Blog readers will probably be hearing more from the rational economist hand, because rational economics makes better reading than regression coefficients. Here’s the case:

1. Oil, the biggest contributor to rising prices thus far, is traded in a speculative market. Therefore, its price should be approximately a random walk, perhaps with some slight drift, but certainly it shouldn’t rise rapidly year after year after year. At any particular point in time, our best guess should be that the oil bull market has run its course. (This point is worth a whole post, so I won’t pursue it further now.)

2. Rent, the newcomer on the inflation scene, is being pushed up by rising interest rates. If rates remain high, rents could stabilize at a higher level, but they should eventually stop rising. Considering the dramatic amount of residential construction activity over the last few years, the longer-term fundamentals for rents are probably a bit bearish.

3. Labor, the major component of costs, shows no signs of being a source of inflationary pressure right now. If anything, the labor market is still quite weak. (I know this point is controversial, but personally, even my quant hand is convinced.)

4. Ben Bernanke, as the new kid on the block and facing circumstances that put his inflation-fighting credibility to a dramatic test, has every reason to prefer erring on the hawkish side rather than the dovish side.

5. The dollar, if it comes under severe selling pressure in the near future, is likely to do so only because of a disinflationary downward turn in US economic growth. Under such circumstances, foreign central banks will still have incentives to support the dollar aggressively enough to prevent any inflationary impact in the US. (Of course, given a few years, if, for example, China’s economy starts to boil over and Japan’s phoenix rises convincingly from the ashes, these incentives may disappear. But then see reasons 1-4.)

“Yeah, yeah, yeah,” says the quant hand, “I’m already taking the weak labor market and the tight [so far] Fed into account, and I still say, buy TIPS.” As a devout quant, he (she? la mano) thinks you should never allow mere (“subjective”) verbal arguments to outweigh the recommendation of a quantitative model.

I’m just making sure I don’t hold my hands too close to my face, or I might get caught in the middle of something ugly.

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8 Comments:

Blogger Dave Livingston said...

Well as a mere real-world pragmatist perhaps we could let the 'gripping hand' point out that YOY% increases in various inflation measures are in fact rising and look to be headed, depending on measure, for 3%+.

The real conundrum is that PPI and it's various components are rising significantly faster than CPI. Which at best means escaling profit pressures which, for the macro-economy, means slowing business spending. Since consumer spending has been pretty much housing driven and that punch bowl is leaving the party....

And, oh yeah, we might have a new structural phenomenon to discuss. In a world of lowered demand by business for labor but increasing cost pressures on materials, components and goods will inflation follow the same post WW2 dynamics ? We are after all facing major structural shifts that might require the quant-hand to rexamine the models, perhaps ?

Thu Jun 29, 05:47:00 PM EDT  
Anonymous Barry said...

Two comments - first, the labor market is indisputably weak. Look at the job creation rate over the last five years, and median real wage growth.

Second, oil might be traded in a speculative market, but how far ahead does most of the market work? I remember seeing, in late 1998, articles about how the stock market was overpriced, but how could I have hedged a year or two out? A 90-day put is a risky bet - not just that the market will go down, but that it'll do so very soon.

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