Inflation Potential

Consumer Price Index:
Yr/yr % 12 months (Mar.)....2.7%
12 month (Smoothed)..........1.7
36 month (Smoothed)..........1.7

Inflation pressure gauges began to re-accelerate in mid 2010, largely reflecting a very sharp rise
of commodities prices since then. Chart

It is typical for inflation pressure gauges to rise fairly sharply when the economy enters a new recovery period. With rising sales and production, capacity utilization recovers in a "V" pattern and commodities
prices rise on higher final demand and the refilling of inventory pipelines.

New cyclical bouts of inflation seem invariably to begin with rising commodities prices and we are
seeing that now. Countries where fuel, food and basic industrial goods form an especially large part
of the consumer spending $ such as China and India are being hit hard. In the US, spending for such
basics constitutes a far smaller part of budgets. Moreover, the US is an extremely efficient
processor of such goods. Even so, inflation is accelerating.

Viewed historically, the US inflation pressure gauges are now in uptrends which are too sharp to
have proven sustainable in the past. So one has to be careful in straightlining the kind of momentum
we have seen recently (See $CRB chart above).

The broad and more important CPI measured to exclude fuels and foods has also finally turned up
after a lengthy period of deceleration which actually runs back to 2006. This measure is up 1.2%
yr/yr, and I would look for it to accelerate right into 2012 as the more basic cost pressures are
passed on. This too, is a perfectly normal development.

Wage growth tends to follow the CPI in the cycle, and consumer spending is not necessarily badly
affected by a falling real wage so long as employment is growing and folks do not mind using
credit to sustain their spending. People have been reluctant to borrow in this recovery, and
consumer confidence is often adversely affected by a sharp rise in fuels prices such as we are
witnessing now, save for natural gas.

The dynamic at work now suggests that a cyclical acceleration of inflation may be more muted
than one might expect unless the there is a rapid catch up phase in the wage or folks loosen up
more in using credit to finance purchases beyond autos and homes. At the same time, it would be
very unusual if the "headline" CPI (which includes fuels and foods) did not reach 3.0% yr/yr
and stay at or above that level for a goodly period. Failure of the CPI to behave thusly would
not be such a healthy sign as it would signify consumer caution perhaps substantial enough to
suppress overall econmic growth.

US Treasury bond yields rose sharply over the five month period ending Feb. '11. It is
interesting that the market has since been stabilizing despite the continued upward pressure of
the inflation pressure gauges I use. The bond market action suggests speculation that the
fast recent rise in fuels prices will bother consumer confidence and spending. The longer
Treasury market is hardly an infallible indicator, but is a damn good one, and well worth
watching to see if the economy is slowing and if the inflation pressure gauges might be set
to ease. We'll see.