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This column was originally published on RealMoney on May 31 at 3:22 p.m. EDT. It's being republished as a bonus for readers.

Earlier this year, the U.S. economy saw the strongest GDP growth in three-and-a-half years after shrugging off record oil prices, rising interest rates and a devastating hurricane. The jobless rate remains at its lowest level since the 2001 recession began. If anything, many say, it's inflation, not growth, that's the problem.

No wonder the uptick in core inflation a couple of weeks ago helped spark the recent market selloff. But it's a little late in the day to worry about inflation. After all, about 40% of the core CPI is rent, where inflation is now rising as homes become less affordable. This is partly due to higher interest rates that are forcing more people to rent instead of buying homes.

The current core-inflation scare is the mirror image of the

deflation scare of 2003, which was just as misguided, for similar reasons. And yet, some want the


to raise rates further, knowing this will eventually boost rental inflation, and thus core inflation. Somehow, that doesn't compute.

Certainly, six months ago, when most were anxious about economic growth prospects, I noted that it was

inflation, not growth

, that should be the real concern because ECRI's Future Inflation Gauge (FIG) was at a five-and-a-half-year high. Sure enough, interest rates have risen significantly since last fall.

But the CPI, or personal-consumption expenditure (PCE) deflator, headline or core, are all coincident indicators of inflation at best. Unless you think their direction won't change for a year or more despite the well-known cyclical nature of inflation, those indicators are hardly relevant to the Fed's actions, which affect inflation with long and variable lags.

That's why policymakers need forward-looking indicators to foresee the bends in the road. The FIG, a measure of underlying inflationary pressures, does just that. And the FIG has been in a mild downtrend for six months, meaning that underlying inflation pressures have actually eased a bit since the fall.

Double Jeopardy

Underlying inflationary pressures are less of a problem today than they were a few months ago, but economic growth may now be about as good as it gets in this cycle.

Two years ago, when many were prematurely pessimistic about home prices, ECRI's

Leading Home Price Index (LHPI) predicted that home prices would keep rising. But the LHPI peaked a year ago, followed by peaks in new and existing median home prices last fall. The trouble is that the LHPI is still sliding. Translation: At a national level, home prices will keep falling for now.

That's a real problem. When I wrote right after Hurricane Katrina that the

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economy was still resilient, my confidence was based on my knowledge of ECRI's leading indices of economic growth, which had benefited from strong home-price appreciation.

That's no longer the case, and with home prices continuing to slide, a consumer spending slowdown is likely. With energy prices taking a big bite out of consumer budgets, the impact is likely to be even worse.

But while many in the markets see that coming, what they don't see is the double whammy, as industrial growth is also set to slow. What does ECRI know that others don't? Most importantly, we see serious weakness in our proprietary long leading indicator of industrial production growth presaging an upcoming industrial slowdown.

As the chart shows, cyclical peaks and troughs in ECRI's industrial long leading indicator (top line) have substantial leads over peaks and troughs in standard leading indicators of industrial growth, such as the ISM new-orders index (middle line), which, in turn, have short leads over actual industrial production growth (bottom line).

Many see the current strength in industrial growth as an omen of future strength, even though it's just a coincident indicator. The better-known leading indicators of industrial growth, like the ISM indicator and commodity prices, may have dipped lately, but are still considered strong. But the chart suggests a very different conclusion.

Notice how ECRI's long leader (top line) bottomed in mid-2004, followed by a trough in ISM new orders (middle line) last May. Finally, industrial growth bottomed last September and has risen noticeably of late.

But the long leader (top line) also peaked in mid-2005 and has been in a cyclical downturn for almost a year. Given the historical record of sequential turns in these indicators, it is possible that ISM new orders (middle line) may have peaked this February, or else may peak soon. If so, the peak in industrial growth is probably not far away.

In other words, even if some industrial indicators look healthy in the near-term, a cyclical slowdown in industrial growth is likely to hit in the coming months, perhaps around the time the consumer spending slowdown starts to bite.

If so, we should now worry much more about growth than about inflation. But things aren't ever that simple, are they?

Fed in a Box

The problem for the Fed is that, even if it foresees this economic weakness, the markets may not agree. In fact, Chairman Bernanke may not yet have the inflation-fighting credibility that would make the markets accept a diagnosis of economic weakness until it's staring us in the face.

On the contrary, dovish hints from the Fed could cause the dollar to drop, while the bond market vigilantes drive longer-term yields higher.

That would be even worse for economic growth down the road, especially if the Fed's forced by market expectations to hike rates more than needed. But unless the more commonly followed market-moving numbers weaken clearly, and soon -- which is uncertain, the Fed will be in a bind. If so, it'll take some delicate maneuvering to keep the economy on an even keel.

Anirvan Banerji is the director of research for the Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City and and is the co-author of

Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy

. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he appreciates your feedback;

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