Lately, there have been more and more calls by mainstream analysts and economists that inflationary pressures are now set to rise in the U.S. economy. In turn, such an increase in inflationary pressures will be tempered by a controlled increase in interest rates that will provide the perfect "cocktail" for stronger economic growth. This is quite a feat for the Federal Reserve to perform as they try to control an economic variable that has historically proven to be fairly uncontrollable.

Nevertheless, there has been much hope pinned on the Federal Reserve's ability to spark a controlled inflationary increase into the U.S. As I addressed in June of 2013, the Fed'sbiggest fear has been "deflation," to wit:

"The Fed's biggest fear has always been the fear of deflation as it erodes economic prosperity over the longer term. Furthermore, outright deflation is a very hard cycle to break as it becomes embedded in the consumer psychology.

Low inflation, as discussed, drags on economic growth, wages, and living standards."

The question remains as to whether there are rising inflationary pressures in the economy. To answer that question we can look at several different inflation measures to judge just how much inflation there really is and whether the Fed is potentially "jumping the gun" by threatening to raise interest rates next year.

This discussion would be remiss if I did not start with CPI to establish a baseline with which to compare other measures.

When analyzing inflation, the month to month changes, annualized rates, etc., tell us nothing about the trend of inflationary pressures. Therefore, the only way to know if there are truly inflationary pressures present is to look at the annual changes in the data. This is shown in the chart below of both the headline and "core," less food energy, measures of CPI.

The increase in both "core" and headline CPI certainly does suggest that inflationary pressures are on the rise and are flirting with the Fed's target of 2%. However, the problem is that over the past five (5) years, CPI has been unable to sustain that 2% level as the deflationary pressures globally continue to pressure domestic inflation lower. The deflationary pressures in the Euro-area (18 major countries) will likely continue to weigh on any potential pickup in inflation domestically.

However, outside of these "official" measures of inflation, other relevant inflation gauges can also help us understand whether the current levels of inflation are sustainable. 

It is worth remembering that inflation is ultimately driven by economic activity. While there are certainly signs of economic activity, it has consistently been "below par" with a continued pattern of "fits and starts" since the end of the financial crisis. One measure of"real activity" on a global basis can be seen in the Baltic Dry Index, which is a non-traded index of shipping prices. Increases in demand to ship dry goods globally should be reflected in higher shipping costs.

As shown, there is a "lag" between changes in the Baltic Dry Index and CPI. The uptick in CPI was expected due to the rise in costs of shipping in 2013.  However, the collapse in shipping prices since the beginning of the year suggests that domestic inflationary pressures may weaken in the months ahead.

Furthermore, the price of copper can also be telling of inflationary pressures. Copper, also known as "Dr. Copper," has a high degree of correlation to the overall economy as it is a base commodity in EVERYTHING that you use, consume, wear, communicate with, etc.  From houses, to transportation to cell phones, copper is either directly or indirectly involved. Therefore, copper prices are not only a reflection of the demand of economic activity but also has a very high correlation to overall inflationary pressures.

Copper prices remain in a long-term downtrend, and there is no evidence currently that copper prices are about to make a shift higher. However, it will be worth watching copper prices in the future as supporting evidence of sustained higher inflationary pressures.

The High Inflation Index

Since the beginning of the Federal Reserve's monetary intervention programs, there has been a consistent chatter that the "excess" printing of money will lead to "hyperinflation."This has not been the case, as discussed in more detail here, but that study of the real drivers of inflation led to the creation of the "high-inflation" index.

That index is comprised of three primary components which are required to create an inflationary environment.

While rising commodity prices is certainly one of them, as it has an immediate impact on the consumptive capability of the average consumer, it is not all that is required for inflation to take hold. In order to see true pricing pressures across the economy it requires; 1) an increase in the velocity of money, or how fast money is flowing through the system from the banks to small businesses and ultimately consumers, and; 2) wage growth which gives the consumer increased purchasing power.

It is very difficult to have a "general rise in price levels" amidst a lack of consumer demand driven by suppressed wages, high levels of unemployment and little demand for credit by businesses. What demand for credit there has been since the beginning of this year by corporations can be directly tied to increases in stock repurchase programs and dividend payouts rather than increased production at levels beyond immediate demand. The ongoing lack of demand exerts downward pressures on the pricing of goods and services keeping businesses on the defensive. This virtual spiral is why deflationary environments are so dangerous and very difficult to break.

The "high inflation" index is an equally weighted measure of the Velocity of Money, the Year Over Year (YOY) percent change in wages and the YOY percent change in the Consumer Price Index (CPI). The first chart shows the historical levels of each of the three individual components.

Notice that there is a historically a fair degree of correlation between the rise and fall of compensation of employees and the velocity of M2 money supply. With M2 velocity plunging to historically low levels, this does not bode well for sustained increases in employment or compensation as the demand for money simply does not exist currently.

The next chart is the weighted average of the three components combined to make the index. 

The index clearly shows the "high inflationary" pressures that were prevalent in the 1970’s as the economy suffered real inflation and rapidly rising interest rates. Recently, inflationary pressures rose as economic growth surged from the lows of the financial crisis as the economic system was flooded by trillions of dollars of stimulus, bailouts and financial supports.  However, that surge, in both the economic growth and the inflationary pressures, peaked in early 2011 and have been on the decline since.

While there have been "fits and starts" to increased inflationary pressures, such activity has corresponded with the same "fits and starts" of the domestic economy. Currently, the index is confirming the recent increase in reported inflation, but it is important to understand that these upward pressures remain well contained in a current "downtrend."

With deflationary pressures from overseas still prevalent, it is very likely that the current uptick in inflation may be fleeting. This potentially could put the Fed at "risk" of moving too soon to extract support from the economy and beginning to increase interest rates in anticipation of stronger growth.

Janet Yellen faces a crucial battle. If she raises interest rates too late, the excess accommodation potentially leads to rapidly rising inflationary pressures that crushes economic growth.  If she acts too soon, an increase in interest rates and reduced accommodation deflates the burgeoning economic recovery. It is an extremely fine balancing act that throughout history the Federal Reserve has never gotten right. While the Federal Reserve certainly displays extreme "confidence" in their abilities to control the situation, the reality is that the economy is a "fickle bitch" that is hard to control and easy to anger.

Tags: InvestingEconomics

Lance Roberts