Reflexive Inflation?

July 18, 2007

One of my favorite indexes, and certainly one of the mostimportant in the world, is the Consumer Price Index (CPI).

It's a thoroughlyflawed measure of inflation, as I explained in this Journal of Indexesarticle in January 2005. But it remainsone of the most important indexes in the world, with billions and billions ofdollars in government spending tied to it. A new CPI report came out today.

Federal Reserve Chairman Ben Bernanke takes the stand atCongress today to provide his mid-year update on the economy, and he's sure tomention the CPI. With that in mind, I was reading through a few of Bernanke'sspeeches recently to get a feel for his thoughts on this critical index.

The big issue in the inflation debate right now is whether risingcommodity prices reflect a real inflationary threat. The core CPI ignores foodand energy as "too volatile," and Bernanke agrees with that decision to apoint. But while reading through hisMarch speech to Congress, I came across this interesting little tidbit.

After dismissing the impact of energy prices, he admits thatthey could have an impact ... if we start worrying about them.

"Another significant factor influencing medium-term trendsin inflation is the public's expectations of inflation. These expectations havean important bearing on whether transitory influences on prices, such aschanges in energy costs, become embedded in wage and price decisions and soleave a lasting imprint on the rate of inflation. It is encouraging thatinflation expectations appear to be contained."

In other words: See no evil, hear no evil, speak no evil.

Of course, it's pretty hard to ignore a $50 tab at the gasstation.

The problem with this assumption is that it presupposes thatvolatile food and energy commodity prices are mean-reverting. But if you believein a secular bull market for commodities-a step-wise increase in prices tied tothe rapid industrialization of developing markets-prices might not come backdown. When and if that idea gains currency, Bernanke's vision of inflation reflexivitycould rear its ugly head.


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