Why Give a FIG About Inflation?

This inflation gauge shows we're not out of the woods yet.
Author:
Publish date:

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.

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.

Of course, core inflation was also one of the culprits when alarm bells about deflation were sounded in mid-2003. While deflation was billed as a low-risk event, this presumed there was a small but significant risk of a renewed recession that would trigger deflation. But,

as I wrote at the time, deflation "occurs in periods dominated by recessions. And according to ECRI's leading indicators, a new U.S. recession isn't on the horizon." Indeed, the following quarter saw GDP growth jump to a two-decade high.

Yet core inflation had dropped because almost three-quarters of the core CPI came from housing and transportation. Housing was driven by a measure of rental inflation, which had plunged as more and more renters became buyers, spurred by low mortgage rates. The transportation component of CPI was depressed by falling used-car prices, as more buyers took advantage of zero-interest rates to buy new cars. Ironically,

Fed

rate cuts had helped reduce core inflation, scaring the Fed into making even more rate cuts!

But the most important drawback of core inflation is that it can't tell you when the trend is about to change, because it's a rearview mirror guide to inflation. For that, you need to predict the direction of the inflation cycle.

Predicting the Inflation Cycle

Inflation has both secular and cyclical components. But because growth and inflation don't always move in tandem, it's useful to have separate leading indices to predict the direction of growth and inflation.

Some of the major market indicators are good forecasters of growth. Others are useful harbingers of inflation. Few are good predictors of both.

The granddaddy of market-moving indicators, the payroll jobs number, is a good coincident indicator of employment. It's not too bad in some respects as an inflation forecaster. But it actually misses a third of all inflation cycle turns, and that is the very worst performance among all the major market-moving indicators. In other words, it's failed to issue any warning a third of the time inflation has changed direction.

A better alternative is to bring together the best leading indicators of inflation, from commodity prices to labor market indicators, and combine them into a summary measure like ECRI's Future Inflation Gauge (FIG). The FIG takes the on-the-one-hand and on-the-other-hand out of forecasting by balancing them out and arriving at a definite conclusion about the future direction of inflation. It is designed to warn of a change in the cyclical direction of inflation.

Warning Signs
FIG leaves no doubt about inflation

Click here for larger image.

Source: Economic Cycle Research Institute

As the chart shows, the FIG bottomed at the end of 2003 before inflation turned up, and well before oil prices took off in mid-2004. By August 2005, it was already at a five-year high.

On the cusp of Katrina, the FIG and the WLI were telling us that it was inflation, not growth, that we should be worried about. The movement of the markets in recent weeks has begun to confirm that call.

The problem is that the weak October payroll jobs numbers notwithstanding, the FIG has continued to climb and is now at a 5 1/2-year high. Despite secular deflation in some parts of the economy, driven by globalization and technology, cyclical inflation pressures are mounting. Sure, headline CPI inflation will fall back after September's energy-related spurt, but inflation is likely to keep trending upward in the following months.

While economic growth is likely to moderate through mid-2006 according to the WLI, the FIG is telling us that there's no letup yet in underlying inflation pressures. Until that changes, inflation, not recession, should be the major concern.

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 is the co-author of

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

. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. 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;

click here

to send him an email.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.