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Forward Inflation Consistent with Recession


Energy and food prices may be very high but the broad sweep of price measures in the U.S. are indicating easing levels of demand consistent with recession, according to Lakshman Achuthan, researcher at the Economic Cycle Research Institute.

ECRI's Future Inflation Gauge (FIG), in contrast to other inflation measures -- most notably the Consumer Price Index -- has been edging steadily lower this year, pointing to declines for the CPI about 10 months out.

The FIG is a pragmatic composite of differing measures, the exact mix of which is proprietary....

"These are your big-time drivers of inflation. Essentially the story you're getting is that money-related measures are not running away. On the contrary, we're in a credit crunch. The wage measures are not running away."

Achuthan said the FIG embraces all price theories and measures, from NAIRU to monetarism to the output gap model: "There are proponents of every one of these theories. What you will find is that they all are insufficient. They all have failed in a practical sense at different times. They are very difficult for a decisionmaker to use.

"The monetary framework would tell me something right now and the currency framework would tell me something else. The wage inflation group would tell me another. The commodity-related group would tell me another. They're all valuable theories but they're insufficient in giving us actionable information on their own. They are very carefully put in the future inflation gauge."

Achuthan said the FIG is an "objective blending" of these factors. "We're not saying one is more important than another. But we are giving a nod to 'drivers of inflation.' If we're really true in letting the indicators tell us a story and not imposing one on them, we get what we believe is the most accurate story. And half the time the true story is really surprising, like right now."

The genesis of the future inflation gauge was the long lag in the '70s and early '80s between cyclical shifts in inflation and cyclical shifts in economic growth. The recessions of 1970, 1974 and 1980 all saw the CPI peaking right at the time of recession, periods of course when GDP was already in a downswing. As GDP recovered coming out of these recessions, inflation rates plunged.

"If there's one truism in economics, I believe it's that recessions always kill inflation, every time without a doubt. There's no way around it even in stagflation. Once you're stuck in a recession, your prices are going to plunge."

The FIG has been on a downturn this year, showing a more than 5% year-on-year decline.

Though he stressed that the FIG is not designed to predict recession, he said the ongoing pattern is consistent with recession. "The direction is clear -- down. ... It's definitely telling us that inflation, over the next few quarters, isn't going up. ... You have energy prices spiking, you have food prices spiking.

"You do not have wage prices spiking, you do not have home prices spiking, you do not have prices of discretionary items spiking, and it doesn't look like prices at Wal-Mart are on the rise. If you're going to have a pervasive upturn in the general price landscape, these components need to participate."

Achuthan argues that the CPI, showing a 5.0% year-on-year rate in June, has likely peaked. "I suspect we're past the worst or we're very close to it. I don't think we have much spike in front of us. The demand side of this is falling apart."

Achuthan in fact believes that the U.S. economy is already in recession. "We think we're in a shallow recession right now. Our leading indexes look horrible. Policy makers were simply too late with stimulus."

He said stimulus should have been provided much earlier and to a much a smaller degree. He further argues that the great degree of stimulus that has been added, centered in injections into the banking system, is behind the run-up in commodity prices. Investors, steering away from troubles in the equity, credit and real estate markets, have turned instead to commodities.

"The side-effect of liquidity is bubbles ... I probably argue more than most that the liquidity added belatedly into the economy is a significant part of this pop in food and energy prices. People argue that these prices have gone up due to demand but when we look at the kind of rise we've had, there's nothing that has changed in demand anywhere near related to that rise. What's the biggest thing that's occurred this year? The trillion dollars that been put into the system by the Fed and ECB."

The Future Inflation Gauge for July will be released to the public Friday morning.