About Me

Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Wednesday, June 04, 2008

Inflation -- Longer Term Potential

In recent years I have discussed in this blog how a strong upturn
of commodities prices, particularly oil, initializes an acceleration of
inflation. I am comfortable utilizing this approach to projecting
inflation in the near term, but not in the long run. For longer term
inflation potential, I prefer to work with long range broad money
growth detrended by real economic growth potential. Forget this
method for short run forecasting and also realize that other
credit and economic factors can work to bring in longer run
projections well off the mark.

For money, I use M-2 (cash, checkables, household savings and
money market funds). I detrend 10 year growth with 10 year
real GDP growth potential. Since the 1950s real GDP growth
potential has dropped from 4.0 % to 2.8% currently. From 1989 -
1999, detrended M-2 growth was a scant 0.3%. Inflation pressure
subsided, interest rates fell, and the stock market p/e ratio soared.
However, from o5/'98 through 05/'08, M-2 detrended grew by
3.5% per year. Thus, the US, thanks to Uncle Al, has transitioned
into a moderately inflationary environment, with sufficient excess
liquidity to support the tightened supply/demand fundamentals in
the commodities markets, and re-launch a new inflationary epoch.

As it turns out, the CPI over the past 3 years has averaged close to
the 3.5% mark as indicated by the model. Since 10 year M-2 growth
does not change that rapidly, the 3.5% benchmark is likely to be
around for a while.

Interestingly, there are monetary and credit factors at work now
that may reduce inflation pressure going forward. One is the now
nearly $700 billion blowout in the commercial paper market over
the past 10 months. This has led to a large decline in the growth of
the broader measure of credit driven liquidity. As well, monetary
liquidity, which influences the cash and checkables component of
M-2, has been growing very slowly for several years. Note though,
that these measures need time to work.

This is stuffy stuff, so fear not, I shall not belabor you with it
often.

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