Am I Now Expecting Inflation to Come Back Sooner?

Bob Murphy emailed me:

Your post on the PPI surprised me. Since I thought as of one month ago you were still sure that we were about to crash because the Fed hasn't printed new money in a long long time, I would have thought if anything today's PPI number would bolster you. And yet you are sounding more like me.

Did something change to alter your perception? I.e. the year/year PPI was just as big last month (or basically the same).

I replied:

Climbing interest rates. Before now it looked to me like we weren't going to see anymore in inflation than the numbers show, but with the uptick in rates, to me it is showing increasing demand for funds. I don't think the funds are there but if the Fed starts to print to keep rates down all hell could break loose.

G.L.S. Shackle once wrote of the stock market as being like a kaleidoscope. The stock market, he said, appears to be going on a very specific type course, but then something happens to disrupt the course  in a manner similar to the way the turn of a child's kaleidoscope changes a picture.

The current, post stage one financial crisis stock market, and economy, offer the possibility of many kaleidoscope type events.

First, we have the rebound in the stock market and economy from the post September 2008 panic Normally, one would think that such a rebound would be over by now. But we had the enormous double digit money printing (M2) between September 2008 and March 2009, followed by very stingy money printing. This adds to the upside of the equation, in the near term, but  then the money printing stinginess is a signal of downside action in gold, the stock market and upside action in the dollar. We have the upside action in the dollar, the beginnings of downside action in the price of gold. Only stock market strength fails, at this point, to complete the scenario. But overall the trends appear somewhat clear and obvious and a downturn in the stock market would complete the scenario. It should be added that this is a  deflationary scenario.

But the kaleidoscope may be turning. The uptick in interest rates, especially the effective Fed Funds rate, adds a new factor to the equation. The entire market is working under the assumption that the Fed won't raise the FFR or the IOER until late this year. But the uptick in the effective FFR signals that the Fed may have to act much sooner. If the effective FFR pierces through the upper target of 0.025%. the Fed will have two choices. 1. Raise the OIER, which would keep the current scenario in tact. Indeed, it would accelerate dollar strength, a declining gold price and a stock market collapse. O,r 2. The Fed could attempt to fight the climb in the effective FFR by adding reserves, which would be a turn of the kaleidoscope towards inflation.

It is my belief that in most cases there is time to react once the die is cast. It takes time for markets to react to changes that will impact a cross spectrum of prices. The Fed adding reserves would be a signal that the Fed has changed course from deflationary to inflationary. It would not be a signal that would be fully understood as to its significance by most market participants. For example, once a Fed adding reserves becomes clear, it would be unlikely that gold would jump by $100 an ounce, but such a jump could be clearly justified. So there will be time to move into inflationary positions, once a Fed stance that way is clear.

So am I expecting accelerated inflation right now? No.

But I realize Bernanke could turn the kaleidoscope soon, so I am beginning to think about what such a turn of the kaleidoscope would mean, and how to position for it.