The straight dope on inflation, June 2006

We’ve had a lot of data in the last 48 hours (such as the CPI and PPI numbers), I think it’s time for me to do my thing and dive into the numbers for a no-nonsense bearing on where inflation is heading.

A quick review of my previous thinking: in April I bought a sizable position in RRPIX as a bet that inflation was coming (so I do have money on the line), last Sunday I predicted (correctly it would turn out) that the CPI numbers would be above predictions. So I’ve been expecting inflationary forces and even predicted two weeks ago that the market was about to realize this and go through some dips. Today the market essentially realized that inflation and fed rate boosts were coming and bond prices went down significantly (raising yields). Let us chuck these predictions out the window and see what the current data says so we can get ahead of the herd again.

We can dig into the PPI numbers and CPI numbers for more details. The PPI (Producer Price Index) measures costs to producers of end products. The total number for May on finished goods is a rise of 0.2% total and 0.3% for core PPI (without volatile food and energy). For those who are interested food prices were down -0.5% while energy prices were up 0.4%. If not for the bird flu and other factors depressing meat demand that food number would have been higher and the overall PPI could have looked much uglier. Also, the PPI numbers most people watch are for those who produce final goods to the consumer. There is also a PPI number for intermediate goods (which are sold to other producers to make final products), that number had a core value of 1.1% and is up 8.9% over the last 12 months.

Crude goods (the earliest stage) is similarly up 8.6% over the previous 12 months. Meanwhile the finished goods PPI rise over the last 12 months is only 4.5% so it looks like the consumer facing companies are still sucking up the growing prices. This is verified in the CPI numbers (which reflect what consumers actually observe when buying things) which have risen only about 4.2% over the last 12 months. There is really no way to see this except that consumer companies are going to have margins about 4% lower than they would otherwise have as they suck up the difference between PPI and CPI. Eventually they will also have to push higher prices onto consumers. Higher prices and lower margins are inflationary forces and at this point seem unavoidable.

This suggests rising interest rates and a continued slowdown as profits mellow and prices rise. There will probably be bumpyness in the market but at this point any long term investor should still be willing to ride along with the natural cycles of the market because timing is just too risky. If you need your money during the next few years, however, I recommend setting a fair amount aside because the market will undergo a lot of gyrations as people slowly come to accept what is happening.

In the meantime you can move some cash to vehicles like RRPIX or Treasury Inflation Protected Securities (TIPS) although if you choose the latter watch out for the “imputed gains” tax trap – it’s one of the few ways in the system you can wind up owing taxes on money you never get.

Invest Well…

FW