Why Inflation is No Big Deal Right Now

Investments and inflation have an important correlation. The European Central Bank cited surging commodity prices as a reason for "strong vigilance" against inflation last week. And much to the chagrin of the investing public, the U.S. Federal Reserve steadfastly refuses to follow suit. Another sticking point is that the Fed uses "core" CPI to track consumer inflation, which does not include food and energy — the two sectors which happen to be seeing steep price increases these days. Fed critics like to howl that by ignoring food and energy the Fed is "lying" about inflation and intentionally understating it to keep its masters in Congress happy. I certainly understand why they feel that way. Experience has taught us to view government policy with a healthy dose of skepticism. But in this case, I'm going to have to side with the Fed. As the father of a 15-month-old boy, I buy a lot of milk at the grocery store. Over the course of the past year, I've paid anywhere from $1.50 to $4.00 for a gallon of regular whole milk. Not all grocery prices are this volatile, but milk is as a good a place to start as any. Because wild swings in milk are affected by supply and demand dynamics that have nothing to do with the Fed's monetary policy. They have a lot more to do with weather, import/export restrictions, and the whims of speculators. Many foodstuffs and energy sources share these characteristics. In short, just because milk prices are going up 10% doesn't mean inflation is going up 10%. The U.S. Department of Agriculture recently forecast that prices of many farm commodities—including staples like corn, wheat, and soybeans—will stay high for the foreseeable future due to tight supplies. But the highly-subsidized U.S. ethanol industry consumes 36% of the country's corn crop. Were the United States to open its market to cheaper sugar-based ethanol from Brazil, we would soon find ourselves with a surplus of corn and falling prices. So much for inflation. Energy prices too look vulnerable. In 2010, U.S. crude oil output hit its highest levels in a decade due to an increase in the extraction of "unconventional" reserves, such as shale oil. U.S. oil production is expected to grow by a full 25% by the middle of this decade. And this says nothing of the massive new oil fields discovered in Brazil's territorial waters. Does it make sense to base monetary policy decisions—which have the power to plunge the country back into recession if done badly—on the prices of commodities like these? Meanwhile, home prices continue to grind ever lower, and the retail sector lacks the power to raise prices. Consumer demand, while improving, remains tepid at best. With this much slack in the economy, I cannot consider inflation a credible threat any time soon. The January numbers certainly give me no reason to worry. Headline CPI came in at 1.6% year-over-year, while the core CPI excluding food and energy came in at only 1.0%. These are hardly the kinds of numbers that keep a central banker awake at night. And hardly reason for an investor to panic over the fear of runaway inflation. Charles Lewis Sizemore, CFA, is editor of the Sizemore Investment Letter .
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