Goldilocks Doesn't Live Here Anymore

With the core consumer price index rising at a 1.7% rate over the past year and the yield on the 10-year Treasury note under 4%, inflation appears quite subdued. Then again, oil prices have doubled, other raw materials costs have gained 35% and even Starbucks (SBUX Quote) is raising prices.

What to make of these seemingly conflicting signals? Inflation optimists see a weak economy that can't generate enough punch to support price hikes. Pessimists see a return to 1970s-style stagflation as higher oil simultaneously feeds inflation and curtails demand.

And the real worrywarts in the crowd believe falling prices, even a Japanese-style deflationary spiral, are the primary threat and driver of monetary policy.

Indeed, when it comes to the issue of cost pressures, this is either a golden age for theorists of all stripes, or an incredibly murky, hard-to-define period. It all depends on your perspective.

The Fed, whose perspective arguably matters most, said last week that it still sees the glass half full when it comes to price pressures. Underlying inflation is "expected to be relatively low," the Fed said, allowing the central bank to slowly increase short-term rates before the economy gets overstimulated.

But some economists question whether Fed Chairman Alan Greenspan is moving too slowly, and they argue prices will accelerate -- at least faster than what the market expects.

Investors "are now overly complacent about -- even scornful of -- inflation risks," writes Morgan Stanley economist Richard Berner. A review of bond prices indicates that investors expect inflation to remain at 1.7% or even decline, he observed Friday. Danger signs abound, including higher consumer inflation expectations, according to the University of Michigan consumer survey, increasing operations at factories outside the high-tech sector, according to the Fed's capacity utilization data, and the weakening dollar, which makes imports more expensive.

Over at Pimco, bond titan Bill Gross and friends have been predicting increasing inflation for months. Last week, the firm predicted that the long decline in inflation during the 1980s followed by a rally in bonds in the 1990s was ending and an inflationary period similar to the 1960s was commencing, as illustrated here.

Click here for larger image.

Source: Pimco