Is Inflation Coming Back?

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Most students of the economy are focusing on the Fed’s planned wind down of monetary support,  and that awful swamp known as the housing market. But increasingly I’m seeing smart souls question something that’s been off the table for a few years: inflation. Talking about inflation now is a bit like discussing fur fashions in August, but as the economy gets further from the recession it’s a natural thing to begin watching. Also, the new focus on inflation is not so much a concern about the runaway price increases, the kind that would occur if the Fed chose to monetize the debt, but more of an expectation for low-grade inflation, the kind that props up corporate profits, adds a bit of oomph to retiree income from CDs and money funds, and generally puts an end to all that banter about disinflation.

Richard Berner, the chief economist at Morgan Stanley, is out with a report entitled The Return of Pricing Power. That’s the kind of headline that would make every CEO’s mouth water but it’s still too early in the game to know how big a boost we could see. Berner’s thesis is that the big drivers of disinflation—slack in housing and labor markets— are peaking, and combined with business cutbacks in capacity the ability to push through price increases will grow. He sees core inflation (ex. food and energy) rising near 2% in 2011 (In February 2010, the core inflation rate was just 1.3%.) There could also be a subtle shift in psychology. Here’s how Berner describes it: “A trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses’ and consumers’ outlook for the factors that drive inflation.  It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery.”  There are a few wild cards in this scenario, Berner notes, and housing is a big one. If there’s another rush of foreclosures and another move down in home prices and rents, the inflation outlook would be far modest.

David Bianco, chief equity strategist at Merrill Lynch, is also musing about inflation possibilities, though he sees too much slack in the labor markets for there to be a contagion effect where commodity price gains feed through to inflationary wage demands. Without rising unit labor costs, he says, a rising CPI is just shifting pricing power from consumers to producers (think corporate profits). Bianco also notes that commodity price run ups do not tend to wreak havoc in the bond market the way widespread inflation does, unless, of course, inflation expectations drive up real interest rates. Consider that another wild card.

The bottom line is that inflation is back on the radar but it’s going to be a different kind than many of us remember. We may see it in energy prices, food prices, a slightly richer yield from money funds and perkier corporate profits.  But we won’t likely see it in paychecks. If you’re sitting in the C-Suite that probably sounds pretty sweet. For everyone else it’s a mixed bag.

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