Thursday's employment report painted a pretty bleak picture of the economy. Consumers are already facing a massive wealth drag from housing, and an increasing number are now facing layoffs as well.

Yet, somehow, the consensus is for rising inflation. The one-year inflation expectation, based on Treasury inflation-protected securities' (TIPS) trading levels, is currently 4.31%, up from 2.24% at the beginning of the year. The weak economy and the relatively high inflation outlook have some uttering the S-word: stagflation.

The pervasive inflation talk in the media may be hard to ignore, but ignore it you should. The conditions for a real inflation spike just aren't in place, and making investment decisions with an inflationary view will wind up costing you money.

First, let's talk briefly about what inflation really means to economists. It isn't a rising cost of living, which is probably how the average person thinks of inflation. Clearly, with energy and food prices rising, the cost of living is going up. But inflation is defined as too many dollars chasing too few goods.

In other words, inflation is always and everywhere a monetary phenomenon, the result of the intersection of money supply and money demand. Surging oil prices due to increased demand from China is not inflation. Higher cost of living? Sure. Inflation, no.

Unfortunately, measuring the effect of money supply and demand is nearly impossible. But we can estimate how much money people have to spend vs. how many goods are being produced. This should get at how many dollars are in the hands of consumers vs. how many goods those dollars are being chased.

A combination of unit-labor costs and productivity should do the trick. The following chart compares Unit Labor Costs, Non-Farm Productivity, and Total CPI (all from the Bureau of Labor Statistics). We'll specifically look at 1974, 1979 and 1980 (the three double-digit inflation years) as well as 2007 and 2008 (annualized Year-To-Date).

What Drives Inflation

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We see that labor costs surged (blue bar) in the 1970s inflation spike, while productivity (yellow bar) waned. So it was costing more per unit of labor, and each unit of labor was producing less. Sure sounds like too many dollars chasing too few goods. Looking at 2007 and 2008, we don't see the same pattern. Unit-labor costs advanced at a modest pace, while productivity has been robust.

Another definition of inflation is a pervasive rise in prices over time. In the 1970s, we certainly saw large price increases across a wide variety of goods. That's not happening today. The chart below is a histogram of CPI components for the same years as above. Again, the data are from the BLS, are annualized.

Distribution of CPI Components

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To build this chart, each CPI component was categorized based on its percentage change, with the groupings done in 5% increments. The bars show the percentage of all components which registered a change within the indicated range.

For example, in 1974, 74% of all CPI components clocked at least a 10% price increase, whereas only 2% showed a price decline. Both 1979 and 1980 showed a similar pattern, with at least 90% of all items showing a 5% increase or more.

Today's pattern is completely different. So far in 2008, the distribution of price increases is more evenly distributed. If inflation were on the rise because of loose monetary policy or a weaker dollar, the price of everything would be rising at once. That just isn't the case right now.

Finally, one needs to consider the impact of contracting consumer credit. Part of the effect of money supply is how much banks are willing to lend to consumers. When the

Fed

cuts interest rates, it is trying to encourage borrowing to expand the money supply. But it's clear that consumers' access to credit will be tight for the foreseeable future, mitigating any direct impact from the Fed's actions.

There is scant evidence that we're currently experiencing monetary inflation. And therefore, it is unlikely we'll see any

Fed

hikes in the near future. Yet fed funds futures still price about an 80% chance of a hike by October. Investors holding on to cash hoping to see better investment rates will be in for a long wait. There are much better opportunities in 2- to 5-year bonds, both in municipals and high-quality taxables.

At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback;

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