Inflation Outlook

The broad money supply (M-2) has grown rapidly enough over the past decade to underwrite an
inflation rate of about 5%. But realistically, inflation is not generated in a vacuum, and with
economic demand running well below the level of economic supply, there have been few times
since the Great Recession bottomed in early 2009 when inflation, measured y/y, has exceeded 2%.
As all know, the long term direction of inflation has been in decline since the extraordinarily high
levels seen in the late 1970s / early 1980s. That longer term trend line now has the CPI at 2% and
on schedule to zero out by around 2020. The rapid industrialization of the developing world over
past 30 years has created a large capability to deliver goods and services more cheaply.

The future inflation pressure gauges I use rest heavily on the momentum of broad measures of
commodity prices and key measures of capacity utilization. These measures have been signaling
higher inflation ahead since early in 2016 and have intensified recently as global production has
started to pick up a little steam. As well, another and longer term measure of economic demand
pressure that I use suggests higher inflation running out into 2018. Looking out into next year,
it is not hard to envision the CPI in a range of 3 - 3.5% at some point, especially if oil supply
and demand come into better balance.

Soon, the economy may have hit levels where history shows that the Fed would begin to raise
short term interest rates in a more nearly serial fashion. The Fed has begun to run behind the curve
but continues to appear to wish to proceed to tighten policy in a very gradual fashion. The
gradualist approach could well change if the new administration and the Congress do embark on
a program of stronger fiscal stimulus.

Viewed in the longer run, I think it is far from clear that the ongoing trend of decelerating inflation
has ended. The next recession, if it occurs in the next several years, could bring a return of
deflation pressure and create the need for even more radical techniques of monetary easing. I
suspect the Fed is somewhat concerned about that risk even if most investors and traders are not.

You can link to an interactive chart on the CPI here > Inflation Rate 100 years