Inflation Note

The US economy has been experiencing the strongest inflation impulse or impetus in nearly thirty years. Since mid-'02, the yr/yr CPI % has moved up from a low 1.1% to 3.2% through Q1 '05. The pressure reflects large increases in the prices of cyclically sensitive materials as well as energy. Operating rates in these areas have risen to high levels reflecting strong demand resulting from the economic recovery in the US as well as strong demand from Asian economies, with the latter now having a much larger economic base because of the rapid growth of China and India, particularly.

In addressing inflation pressure in 2005, the Federal Reserve has elected to continue a course of progressive but moderate tightening of the monetary reins. In essence, the Fed is betting that the recent run-up in the prices of oil and natural gas reflect very strong seasonal demand and that oil and gas prices will weaken signicantly as buyers realize there will be ample supplies in the months ahead. The Fed is also aware that with manufacturing and business-commercial sales having outpaced consumer spending and export demand for months, inventories are trending up sharply. The eventual re-balancing of business output relative to consumer demand is expected to result in slower overall economic growth and some price concessions.

If the Fed's judgment is correct, yr/yr CPI% could eventually slide from 3.2% to the 2.5 - 2.7 % range at some point over half 2 '05. It will be an interesting period, because this is the first time in a good several years that the economy faces an inventory overhang. Moreover, since operating rates for finished goods show continuing significant slack, inflation pressure could dissipate readily if the fuels and sensitive materials price composites exhibit weakness.

At present, inflation thrust measures are still too strong. Oil, recently $50-56 a barrel, would need to move down to $42-47 a barrel and stay there for several months if inflation is to decelerate as the Fed hopes. Likewise, The CRB Commodities Futures index would need to go to 285-290 area from the present 300 (While I fiddle with setting up links, you can go to stockcharts.com and pull up $WTIC, $CRB and $NATGAS to play with).

There is a longer term issue here. If the Fed's tightening gambit works, It will find that, as It moves to ease up on the reins down the road, inflation pressures will likely return.It may have to contend with new surges in fuels and sensitive materials prices, and in addition, end stage processing prices may firm faster because slack may be used up quickly.