Why Give a FIG About Inflation?

Editor's Note: This is a bonus story from Anirvan Banerji, whose commentary usually appears only on RealMoney. We're offering it today to TheStreet.com readers. It was originally published on Real Money Nov. 8 at 11:38 a.m. EST. To read Banerji's commentary regularly, please click here for information about a free trial to RealMoney.

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The clear and present danger today is inflation, not recession. That remains true even though the R-word has been invoked from time to time throughout the year. But there's one summary measure that can peer through the fog and provide a beacon about the future direction of inflation -- the ECRI's Future Inflation Gauge (FIG).

Last spring, the markets swooned in fear of the sharp second-half downturn that was flagged by a flock of Chicken Little analysts, forecasting by analogy to historical periods when rising oil prices and interest rates had triggered recessions. At the time, I wrote that "U.S. economic growth will hold up in the second half of 2005" because of the resilience of ECRI's Weekly Leading Index (WLI). I knew that it's only when an array of reliable leading indices like the WLI shows major weakness that oil shocks can trigger cyclical downturns. As worries about growth eased, stocks rallied.

Sure enough, GDP growth actually accelerated from 3.3% in the second quarter to an unexpectedly strong 3.8% in the third quarter. Without the hurricanes, it would have been well over 4%. What were the pessimists thinking?

When Katrina hit, some decided that a recession was a serious threat, which pushed 10-year Treasury yields below 4% in early September. But it was already clear back then that "the underpinnings of this recovery are such that economic growth won't plunge." As those needless fears receded over the last two months, Treasury yields climbed steeply.

The point is that markets can be wrong for a while until they figure things out.

That was true right after the 2001 recession began, when the S&P rallied almost 20% in less than seven weeks in April and May in the expectation of a second-half rebound, before losing all of those gains, and more, before Sept. 11.

Good leading indices like ECRI's Long Leading Index (LLI), which excludes stock prices, are typically more prescient than the markets about the direction of economic growth. When they diverge from the market consensus, they can present an opportunity to the savvy investor. Those divergences have narrowed, but there's still some complacency about the direction of the inflation cycle.

The 'Core' Issue

Even though inflation has been soaring because of energy prices, economists like to point to the "core" CPI, excluding food and energy, as evidence that there's nothing to worry about. But why do they focus so much on the core?

Because inflation tends to keep going up once it's started rising, and vice versa, it makes sense that if you could estimate the underlying trend, it would tell you where inflation was headed. That would work most of the time except, of course, when the direction was about to change -- which is why the trend is a lousy predictor of a change in trend. For that, you need a leading indicator of turning points in inflation (but more about that later).

The point is that many economists figure that food and energy prices jump around so much from month to month that they represent mostly "noise" that distracts from the basic trend. So why not get rid of them? The problem is that since mid-2004, energy prices have been the driver of inflation, not a distraction. To that extent, core inflation is less relevant than it used to be.