Inflation Potential

In the US, the CPI reached an all-time high of 220.0 in 7/08. With the rapid descent of the
economy over Half 2 '08, deflation pressure set in and the CPI fell to 210.2 in 12/08. The
inflation index has been recovering since then, and it should eclipse the prior record 220.0
level relatively soon.

Since the end of 2008, the CPI has recovered by about 2.2% per year. There has been a sharp
cyclical rise of commodities prices, including in the important fuels and foods categories, but
The CPI, exluding the volatile food and fuel sectors, has decelerated persistently since late 2006,
and recently has been increasing at only an 0.8% rate yr/yr.

It can take up to two years from the time the leading economic indicators bottom and start to
recover until the large and less volatile component of the CPI begins to accelerate to the upside.
Since the leading indicators bottomed in early 2009, the large inflation component which
excludes foods and fuels should begin to accelerate in Half  '1 2011. This development, coupled
with a volatile, ongoing cyclical rise in commodities prices, could push the yr/yr CPI to 2.5%
by year's end 2011 and upward to 3.0% on a yr/yr basis by mid-2011. Because of the powerful
volatility of commodities prices, these projections have to be seen as being in the "back of the
envelope" style -- conjecture with a degree of sophistication.

The inflation pressure gauges I use are now trending higher. These measures give heavy weight
both to commodities prices and factory operating rates and both suggest an acceleration of the
CPI from the late '10 1.5% yr/yr level up to 2.0 - 2.5% in the months ahead. It is interesting to note
that when the pressure gauges have eased off as occurred in Half '1 2010, the upward thrust
of the CPI has tailed off rapidly. Such will be less likely once the the broader, less volatile
component of the CPI starts a period of cyclical acceleration.