Insight Line—March 17, 2008

With the price of oil and industrial metals rising concurrent to continued dollar weakness, the question many are asking is, “Are we importing inflation?”

The answer, according to recent research from economists at the Federal Reserve Bank of Cleveland (Fed) is no.

Their logic is straightforward and I believe serves to clarify a common misconception about the nature of inflation. As explained in a recent commentary by researchers Owen Humpage and Michael Shenk at the Cleveland Fed, “Inflation refers to the deterioration in the purchasing power of money that results when a central bank creates more money than the public wants to hold.”¹ As such, with the year-over-year growth rates of M1 and M2 money supply measures² showing little sign of trend acceleration since March 2007, I suggest there is little reason to conclude such monetary-induced price pressure to be the case.

Granted, import price changes hit our most widely followed price indexes as if they are inflationary. Yet, an historical perspective of previous import price spikes argues these price changes actually are reflective of changes in supply and demand for those goods, rather than poorly constructed monetary policy. You see, as Fed researchers Humpage and Shenk remind investors, inflation is “everywhere and always a home-grown central bank problem.”³ Therefore, they argue, price changes such as those recently witnessed in dollar-based agriculture, metal and petroleum products are characteristically transitory, owing to the fact that rising prices create off-sized incentives for new entrants to increase supply, which eventually leads to price declines.

The management of currency values through the exchange rate mechanism is a complex and interactive process influenced by many different forces—most of which are almost devoid of explanation. In fact, most academic research on the subject concludes that the next piece of information, as well as the direction of the next rate move, is random. Even the Federal Reserve Board of Governors’ own research staff once concluded, “The inability to anticipate changes in supply and demand for a currency is at the root of the statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss.”⁴ All of which, I believe calls into question the wisdom of using random exchange rate movements as a viable predictor of inflationary trends.

Please note: The next edition of Insight Line will be March 31, 2008.

¹ Humpage, Owen F. and Michael Shenk, “Are We Importing Inflation?” Economic Trends, Federal Reserve Bank of Cleveland, March 07, 2008. Available at http://www.clevelandfed.org/research/trends/2008/0308/01intmar.cfm

² M1, M2, and M3 represent three different categories of total monetary supply in the U.S. economy. M1 is currency and checking deposits. M2 includes M1 plus balances that generally are similar to transaction accounts and that, for the most part, can be converted readily to M1 with little or no loss of principal such as savings deposits, time deposits and money market funds.

³ Humpage and Shenk, page 1

⁴ Greenspan, Alan, “Panel Discussion: Euro in Wider Circles,” remarks at the European Banking Congress 2004, Frankfurt, Germany, November 19, 2004. Available at http://www.federalreserve.gov/boarddocs/speeches/2004/20041119/default.htm

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 3/14/08)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

February 2008’s payroll employment data offered little in the way of encouragement. The decline of 63,000 moved the payroll total to 137.993 million workers. Granted, such flash statistics are subject to wide revisions in subsequent months. Updates to the household surveys, pegging the total employed in the labor force at 145.993 million confirms, at least for now, employment growth is, at best, merely absorbing new entrants into the labor force. Therefore, until such time that employment growth is once again sufficient to absorb the growth in the labor force. Please circle Down.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

January 2008’s personal income data continues in sharp contrast to other less upbeat data points released since year-end 2007. However, it was not without caution. Real disposable income rose just 0.1 percent over that recorded in December 2007 and 3 percent over the same period a year ago. With that being said, I suggest Up remains the appropriate circle on the table.

Retail Sales
^{(Source: Department of Commerce/Census)}

Up

Down

February 2008’s retail sales registered disappointing results on most fronts. Granted, bad weather did little to support the seasonally adjusted monthly total of $380 billion. Then again, part of the shortfall also lays squarely at the feet of faulty seasonal adjustment factors. Nevertheless, the year-over-year trend attests to my long held position that spending power remains strained. I suggest the appropriate circle on the chart remains Down.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

New orders for manufactured goods in the month of January 2008, reflecting a large drop in civilian aircraft orders, declined 2.5 percent from December 2007. On the other hand, shipments, unfilled orders and inventories registered notable increases. While the overall picture in the nation’s manufacturing sector suggests little more than inventory and sales replacement rather than business expansion, export growth is keeping the manufacturing sector hard at work. In light of this development, I suggest the potential for a near-term contribution to the nation’s first quarter gross domestic product. Therefore, the appropriate circle moves to Up.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

The inflation rate, as reported in the January Personal Consumption Expenditure Index (ex-food and energy), at 2.2 percent year-over-year sits slightly above the FOMC’s preferred range of 1 to 2 percent. Nevertheless, in that FOMC voting members do not seem overtly concerned over the recent uptick, I suggest keeping the circle as Low on the chart until public utterances to the contrary from voting FOMC members is commonplace.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

With a slowing economy and newly authorized spending/rebate legislation, February’s federal fiscal situation is but a hint of what lies ahead. The monthly deficit of $175 billion, due in part to a leap year, gives investors a real-time look at how the deficit will increase as a percent of the nation’s GDP. The appropriate circle on the chart, reflecting economic stimulus, is $In.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC reduced the overnight lending rate to 3.00 percent on January 31, 2008. The committee next meets on March 18 and it is widely expected to reduce the federal funds rate closer to 2 percent. In addition the Federal Reserve Bank instituted the Term Auction Facility and the Term Securities Lending Facility in an effort to provide the nation’s capital markets with an unprecedented and much-needed amount of short-term liquidity. Please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield, reflecting recent Fed moves, now measures in at a positive 220 basis points on March 14, 2008. Please Circle Positive

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The nation’s fourth quarter annualized GDP growth, due in part to negative contributions from new housing construction, inventory sales and trade, slipped to 0.6 percent. As of this publication date, subsequently released data argues for slight upward revisions. While I believe the rising chorus of recession sound rationale, I remain unconvinced as industrial production and export strength argues against such a conclusion. Nevertheless, the prospect of slow growth in the first half of 2008 is all but certain. Therefore, please circle Below.