Shared by my friend David Kotok:
19:28 (36 minutes ago)
Inflation, Crimea, Markets
March 19, 2014
Every month the Cleveland Fed computes and publishes a median CPI and a 16% trimmed-mean estimate of the CPI. They add these calculations to the headline CPI and the CPI excluding food and energy. In a few seconds one can see the monthly rates of change for the last six months and the year-over-year rates of change.
Anyone may obtain this detail from the Cleveland Fed, which makes it available on their website (http://www.clevelandfed.org/For_the_Public/News_and_Media/median_cpi.pdf) and will send it to you as an email. (Contact Joel.Elvery@clev.frb.org.) I read this email notice monthly as it is received.
For the last six months all measures of monthly change have been either 0.1% or 0.2%. There were no expectations for a change of course. The matrix of four ways to view the CPI monthly change in each of the last six months shows 24 data points, and all of them are very benign when it comes to this approach to measuring inflation.
A second panel shows the percent change for the last 12 months. The range of the 24 data points spans 1.2% low to 2.0% high. All points fall within that band.
Let’s interpret this for financial markets and for business planning. First, markets. Inflation is clearly benign as measured by the CPI. It is in a holding pattern of somewhere between 1% and 2%, depending on how one measures it. It is not rising and it is not falling. All this is happening while the policy-setting interest rate in the United States remains near zero. As today’s Fed meeting result will affirm, there is little likelihood that the policy-setting interest rate will change any time soon. And there is little likelihood that the inflation rate will change soon, either.
Financial markets are proceeding with their advance based on this outlook continuing for some time. In the interest rate arena, expectations are that the near-zero rates will prevail for at least another year or two. That means security valuations based on shorter-term interest rates will continue to be robust. Hence, though stock markets may become more volatile and reactive to geopolitical events, they still have an upward bias.
Bond markets seem to be contained within trading ranges. Even the municipal bond market seems to have stabilized now that Puerto Rico has succeeded in its bond issuance and raised $3.5 billion in new cash. Detroit is gradually working out a settlement path. Worries about Chicago becoming the next city “shoe to drop” are in the Muniland conversation. Time will tell what will befall the Windy City. Cumberland avoids Chicago’s city debt; it may or may not become another type of Detroit event but why take the risk.
Stable inflation and lower volatility in the bond arena mean that businesses can be forward-looking in their financial planning. There is a growing sense that some capital expenditures may be made and that some financing may be undertaken. We see some of that with our clients. For planning purposes, a stable, low inflation rate is very helpful and removes the inflation distortions that happen with inventories and financial statements. Earnings portrayed in those statements are of a higher quality in reported terms since they are not distorted by inflation.
To sum up, the inflation outlook continues benign. This means little pressure on the Federal Reserve to change interest rate policy in the near term. So we expect modest but continuing economic growth in the US. It will be coupled with a Fed policy of gradualism, with scheduled tapering until a neutral central bank position is reached. And then a gradual policy shift of the maturity structure of the central bank’s balance sheet will commence.
We are fully invested in our US stock market-oriented ETF accounts.
A word on Ukraine. We expected Russia to “annex” Crimea. Our baseline case was not to raise cash unless we saw actual military movement. We would raise cash in the event of a shooting war. We did not raise cash on the bluster of political talk. Putin had the upper hand, played it, and won. The traditional Western powers had a weak hand and were without any reasonable choice. So they practiced restraint in arms and substituted lots of bluster.
So be it.
David R. Kotok, Chairman and Chief Investment Officer
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