Inflation Noose Is Tightening

03/28/2011 2:32 pm EST


John Mauldin

Chairman, Mauldin Economics

When the Federal Reserve stops buying bonds, the inflation it has unleashed will play havoc with markets and the economy, warns John Mauldin in Thoughts from the Frontline.

The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June.

June is three months away. What will happen when that buying goes away?

The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We’ll survey how that is working out, with a quick look at some recent data, and then we’ll go back and see what happened the last time the Fed stopped quantitative easing.

The Squeeze Is On
First, the guy on the street is getting squeezed. Real US consumer spending slowed in January, and looks like it did only marginally better in February.

The Fed argues that inflation is mild, as they prefer to look at “core” inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month.

But that argument gets a lot weaker when your main policy—that of significant quantitative easing—is perhaps causing the rise in food and energy (as well as weakening the dollar.)

If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don’t count doesn’t hold water. Let’s look at the following chart from


In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis.

Companies like Kimberly-Clark (KMB), Colgate-Palmolive (CL), Procter & Gamble (PG), and others all announced 5% to 7% price increases this month. These are companies that provide staples we all buy. Those prices matter.

Even Wal-Mart (WMT) will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact.

As Toronto-based economist David Rosenberg wrote recently:

“In February, there was no inflation at all in average weekly wage-based earnings, but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate.

“Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted.”

He goes on to give us this chart:


How’s that QE2 thingy working for you, Mr. or Ms. Average Worker? Prices up, income down?

And remember, most workers got the equivalent of a 2% pay hike with the payroll tax holiday, which goes away at the end of the year (and without which the economy and consumer spending would be even worse.)

Next: Rents Headed Much Higher


Rents Headed Much Higher
And core inflation may soon be under pressure as rents rise.

According to CNNMoney, “Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. ‘The demand for rental housing has already started to increase,’ said Peggy Alford, president of By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.”

Look at this graph showing their projections:


If projections are anywhere close, we could see a rise in rents of 15% by the end of 2012. Let’s remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent, homeowner housing costs extrapolated from current rental rates.

If they are right, that adds about 3% to total CPI and 6% to core CPI. Will the Fed be telling us to focus on core inflation in 12-18 months?

Then let’s look at business. The latest Producer Price Index was way up—1.6% for the month, or an annualized 20%-plus. Even if you look at the last year, it was up a real 5.8%. That is inflation in the pipeline.

Look at this chart from, and notice the trend since QE2 was announced in August and implemented in November.


The point is that the Fed has created real pressure in the price pipeline, primarily on basic commodities and energy.

“Crude” goods, basically materials before there is any value added, are up 28% from a year ago—and pushing an annualized 35% to 40% for the last six months. Those costs are filtering into final finished products.

What Happens When Fed Steps Aside
We have only one instance where the Fed cut back on quantitative easing, and that was last year. It is a data set of one, but it is all we have. So, let’s look at what happened when the Fed let its balance sheet contract by some 12% from late April to late August. Data from Rosenberg:

  • The S&P 500 sagged from 1,217 to 1,064
  • The S&P 600 small caps fell from 394 to 330
  • The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words, the defensives. The worst performers were financials, tech, energy, and consumer discretionary.
  • Credit spreads widened
  • Commodity futures dropped
  • Oil went from $84.30 a barrel to $75.20
  • The CBOE Volatility index jumped from 16.6 to 24.5
  • The trade-weighted dollar index firmed to 76.5 from 75.5
  • Gold was the commodity that bucked the trend, acting as a refuge at a time of intensifying economic and financial uncertainty and rising to $1,235 an ounce from $1,140
  • The yield on the ten-year US Treasury note plunged to 2.66% from 3.84%

What will happen this time around? Is the economy strong enough to grow on its own without stimulus, or weak enough that the Fed will be reluctant to continue without QE3?

Growth Forecasts Slashed
My friends at Macroeconomic Advisors have reduced their first-quarter GDP projection to 2.5%. Morgan Stanley has dropped theirs from 4.5% less than six weeks ago to 2.9% today. That is a huge drop in a short time for a forecasting model.

Forecasts at other economic shops are being slashed as well. States and local governments are cutting more than 1% of GDP from their budgets. That translates into real-world pressure on the GDP.

I am not ready to invoke recession, but Muddle Through could show up with a true vengeance this summer, with higher inflation and slower growth. I lived through the ’70s, and frankly, I would just as soon not see that movie again.

The danger here is that the Fed (and particularly Bernanke) watch the economy slow and decide we need another round of quantitative easing.

Another round of QE, unless there is a true liquidity crisis—and the last QE did not qualify—would be a disaster. There are all sorts of inflationary and stagflationary consequences.

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