Sound, Fury but No Inflation

Though powerful economic forces rage around it, inflation remains calm.

The latest evidence is the government's consumer price index, released Tuesday. It showed prices retreating 0.2% in November, or 0.1% factoring out food and energy. While it is the first contraction since April, it is consistent with a series of reports showing inflation to be close to nonexistent.

An unprecedented combination of monetary and fiscal stimuli coupled to send economic growth on an 8.2% tear in the third quarter of 2003. And the economy has remained strong since then. Industrial production figures Tuesday showed a 0.9% increase in November, the largest increase since October 1999.

Yet despite the best growth rate in 20 years, the Federal Reserve remains a formidable offset, holding interest rates steady at a 45-year low of 1%. With strong growth and real interest rates practically in negative territory, inflation will continue to get a lot of attention in the coming year.

"Peering into next year, the inflationary character of the economy will likely prove the most important issue facing economists, policy officials and investors," said James Paulsen, chief investment officer at Wells Capital Management.

Inflationary pressures are already mounting: commodity prices have surged this year; the dollar is hovering near an all-time low vs. the euro; tuition costs are skyrocketing and skyrocketing health care costs show no signs of slowing. Powerful forces line up on the other side, however, including higher productivity and the weak labor market.

So should investors begin positioning portfolios for a nasty dose of inflation and a vicious rollback of Fed rate cuts? Most economists say no. The overwhelming consensus is that inflation will be mild in 2004. What's arguably more alarming is the unanimity of the consensus. Even its proponents wonder if such complacency could lead to grief.

Looking for Inflation

"Seldom do we remember a time when there was more policy juice being brought to a recovery," noted Paulsen. "The Fed has been in an easing mode for almost three continuous years -- government deficit spending in the last year is in excess of $350 billion [or more than 3% of GDP] -- and the U.S. trade-weighted dollar has declined by about 25% from its 2002 highs. This list has to be the economic policy for creating inflation."