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Stagflation? Don't Get Fooled Again.

THERE'S BEEN A LOT WRITTEN LATELY about stagflation, which makes me think of the late Sen. Lloyd Bentsen's riposte to then-Sen. Dan Quayle in their 1988 vice-presidential debate.

I lived through the 'Seventies; I know stagflation; this is no stagflation.

Oh, there's the "stag" part, or worse. The Institute for Supply Management's manufacturing survey dropped to 48.3 in February, below the 50 dividing line indicating a contraction in factory activity. Weak economic numbers evidently carry no further terror for the markets as they scarcely reacted Monday to this latest evidence of a recession, which, Warren Buffett said Monday, we are in "by any commonsense definition."

As for inflation, the consumer price index was up 4.3% in February from a year earlier, the highest rate of retail inflation in 16 years. That doesn't exclude those nettlesome food and energy prices that the government has tried to get everybody to ignore since the early 'Seventies, when President Nixon's minions came up with the concept of "core" inflation, as in rotten to the.

The clearest parallel between that misbegotten time and now seems to be soaring commodity prices. Back 30-odd years ago, commodities entered the popular culture the way dot-com stocks did in the 'Nineties.

Fast forward to today, and crude oil has shot past $100 a barrel while gold is closing in on $1,000 an ounce. As a result, Federal Reserve Chairman Ben Bernanke had to parry questions last week about the central bank's commitment to price stability in testimony before Congress while the so-called bond vigilantes have been making noises about the threat of inflation -- even as they bid yields still lower in the Treasury market.

But is there any reason to believe that we are about to enter a period of sustained inflation, which becomes embedded in the public's psyche, as in the 'Seventies? Based on a reliable leading indicator of inflation, the answer is no.

The Future Inflation Gauge published by the Economic Cycle Research Institute has been steadily pointing lower, notwithstanding what's been happening in the commodities pits. If you haven't heard of ECRI, it was founded by the late Geoffrey H. Moore, who invented the concept of leading indicators to call cyclical turns in the economy. He also was a professor of Alan Greenspan's, which shouldn't be held against Moore's legacy.

The FIG, as the folks at ECRI like to call the indicator, has been dropping steadily for more than a year. In January, it was falling at an annualized rate of 3%, which was a slower pace than December's minus 4.4%, but still was clearly negative. And it stood in sharp contrast to the rising trend in the CPI, which, if the FIG is right, ought to be peaking.

ECRI managing director Lakshman Achuthan flatly calls the inflation concerns "a red herring."

He does concede there are concerns relating to the Fed's previous attempts to counter the bursting of bubbles, which has led to inflating new ones. After the Long-Term Capital Management bust in 1998 came aggressive Fed easing. Then, also in anticipation of the Y2k bogeyman, the Fed flooded the financial system with liquidity. The result -- the tech bubble. To counter that bust and the effects of 9/11, the Fed drove short-term rates down all the way to 1% and raised them at a glacial pace, resulting in the housing bubble.

Now, to counter the housing bust, Achuthan points out, the Fed's easing moves mainly are working to boost commodity prices. Investors are channeling this money not into stocks, credit instruments and certainly not real estate, but a relatively low-risk asset class, commodities.

But this money mainly seems to be spurring prices of commodities that have exchange-traded futures contracts, such as oil, grains and precious metals, suggesting the rise in these prices is at least partially speculatively driven. Prices of humble industrial commodities -- which are measured in the JOC-ECRI index but aren't traded in some frenetic televised pit, such as red oak, rubber, burlap and such -- are up less than 10%, Achuthan points out. By contrast, exchange-traded commodities have more than doubled.

What's really strange is how the housing bust actually boosts the CPI. One of the biggest components in the index is shelter costs, either rent or what's called "owners' imputed rent." The latter is a guess of what homeowners would pay to rent the house they're living in. This is a contorted attempt to separate the service "dividend" a homeowner receives from his or her house as shelter, from its "capital gains."

During the housing bubble, Achuthan explains, rents were depressed because the widespread desire to buy one's own abode, aided and abetted with all forms of easy credit. That artificially depressed the CPI earlier in the decade when rents were suppressed. Only in a government statistic could rising house prices work to lower inflation.

Conversely, rents now are rising because of the understandable reluctance or inability to buy houses or condominiums because of plunging prices or tight credit. Achuthan thinks the Fed now realizes its error in misreading the distorting effect rising house prices exerted on the suppressed CPI earlier in the decade.

Conversely, he continues, Bernanke & Co. also now sees the distortion in the mirror image now being seen. That is, rents are being boosted by households seeking to avoid the effects of the crash in home prices. They're either wisely waiting to commit to buying a house. Or they can't get a mortgage now that it takes more than a pulse to qualify. Or, tragically, they have lost their homes in the tsunami of foreclosures.

To be sure, the Fed can't control the demand for commodities from Asia, Achuthan says. And, he further notes, all 19 economies tracked by ECRI are looking weaker. That should put a cap on commodity prices. Even if oil stays at the exalted level $100 for the next 12 months, that would still result in zero inflation over that period. Inflation means a change in the price level, not just that prices are high.

Basically, by ignoring asset markets, the Fed was deluded into thinking there was no inflation in the 'Nineties or earlier in this decade. Now, the price of the most important asset to most Americans -- and, as it turns out, the global finance system -- U.S. houses, is in free-fall. Yet, the main measures of inflation are rising.

As Pete Townshend of The Who famously wrote at the beginning of the 'Seventies, the Fed won't get fooled again, either by phony inflation or the real thing. Neither should you.