Inflation

My primary inflation gauge has dropped as rapidly as it does
when the economy is entering a period of recession. As all
must know by now, the primary culprit behind the blowout is
energy pricing -- oil, petrol products and natural gas. In
fact the weakness in energy prices dominates the fall in
commodities, especially on a usage basis. So we do not have
the kind of broad based erosion in materials pricing that
attends a business downturn.

Spare capacity in oil at the wellhead, which might have dipped
slightly below 1 million bd at its nadir, has now advanced to
around 2.5 million bd. Demand growth has moderated, first because
of how high the oil price went, and now because of a strong
contra-seasonal factor in the form of warmer weather. Supply
capability is expanding as expected and there is word that OPEC
is cheating on announced production cuts, again as expected.
As discussed in earlier posts on oil, carry stocks had reached
multi year highs this past summer. So I see the weakness in
oil primarily reflecting the unwinding of speculative excesses
and the return of the market back toward equilibrium. Much the
same can be said for the collapse in natural gas over the past
year as well, except that gas is a tougher call because of the
continuing tightness in storage and pipeline throughput capacity.

I have equilibrium pricing for oil in the mid-$40's per bl and
for gas at $4-5.00 per mcf. Whether either commodity will trade
down to and remain at those equilibrium levels for a while is
anyone's guess as far as I am concerned, but I suspect there are
enough sadder but wiser beavers out there to leave these markets
tamer for a spell, once the proverbial dust has settled.

Since the leading inflation index has not bottomed yet, odds are
that so-called "core" rates of inflation may not have either.
Discussion of the outlook for inflation does need to be tempered
by the fact that the leading indicators rarely make extended
bottoms, but tend to turn up quickly when they turn. What is
interesting here is that we have witnessed blowouts in certain
commodities composites not so much because final demand has
tumbled, but more because of the unwinding of speculative excess.
The re-energizing of the speculative appetite could take a bit
longer in such circumstances.

There are a couple of other factors to keep in mind regarding
inflation. The Fed remains tight with monetary liquidity. Measured
yr/yr, Fed Bank Credit has advance by only about 3% a year since
the end of 2004. That is a "disinflationary" factor to say the
least. Secondly, with the US trade deficit appearing to stabilize,
a primary source of incremental dollar liquidity to the global
economy has dried up. That is both an economic growth and inflation
headwind factor.