Inflation Potential -- Long Term

To come up with longer term potential, I use a "back of the envelope" model that has
worked very well for a number of years. In brief, I subtract a real economic growth
assumption from the 10 year annual rate of gain for money M-2, the most stable of
the aggregates. Over the past decade, M-2 has gained by 5.8% per year. My growth
factor combines reasonable projections for annual increases in both productivity and
for the labor force. This assumption works out to about 2.8%. Thus, I peg longer run
inflation potential at 3.0% per year. M-2 has been decelerating in the long run as has
real growth potential for the US based on a downturn in the growth of the labor force
(Productivity has been improving as a partial offset to lower labor force growth).

The yr/yr CPI has averaged 2.1% over the past six years on a 60 month smoothed basis.
The period encompasses 6 / 2007 through 6 / 2013 and includes a very deep recession
and below average economic recovery. The excess output capacity and weak labor
market over this interval primarily accounts for the shortfall of inflation compared to
the 3% projection and extremely sparse credit growth has played a roll as well.

Supported heavily by the Fed's QE programs, M-2 has begun to accelerate since 2010
and has been growing about 7.5%. This progress has been undercut by weakness in
other important measures of bank funding such as "jumbo deposits" ($100K+) and
financial sector commercial paper. The inflation rate since 2010 has averaged 2.2%
when measured on a smoothed yr/yr basis.

In the US, business capacity utilization should average about 80 - 82% in a stable
growth environment and the unemployment rate should run lower than currently. But,
the nation's operating rate has not topped the 80% level since 2008, and the economy
has not run near full or effective capacity for almost 20 years. Moreover, wage growth
over the past 10 years has barely been strong enough to support 3% inflation.

When we look out over time, it will become increasingly difficult to hold inflation
at or below 3% if some mixture of monetary easing plus faster credit growth puts new
upward pressure on that 10 year M-2 growth rate.

looking in the shorter run, inflation has been running 100 basis points below where it
should be and since fails in monetary and / or fiscal policy can punish output in an
economy with still substantial idle resources and relatively high debt levels, you should
realize the latent deflation potential in the outlook until there is a more sustainable
strengthening of real output, wages and pricing power. The US is not out of the woods
yet and I would happily trade a brisker economy with 3% inflation over what we have
been experiencing.

Many people scoff at the CPI and substitute their own measures to suit their convictions.
Do not be a fool. The CPI is a good approximation of inflation in the US system.