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Farrell: I Don't Get It

Monday, 18 Apr 2011 | 9:19 AM ET

Last week the Producer (PPI) and the Consumer (CPI) price indices were released. There was plenty of meat for both sides on the inflation argument. The headline PPI rose 0.7% from a month earlier, primarily because of higher food and energy prices.

The "core," which strips away food and energy, was up a more modest 0.3%. But even the core rate is starting to accelerate. While up only 1.9% from a year ago, the core has advanced at an annualized rate of 4.2% over the last three months. It appears that manufacturers are starting to pass along the higher prices of commodities they are experiencing.

Remember, the reason both headline and core are reported has to do with the fact that no one central bank can exert much influence on food or energy prices as they are global commodities. Thus the headline report.

The core is reported to see if what one country can't influence is raising the overall rate of inflation on other items in that country. That's why they report the core rate. It appears as though the price increases are filtering through.

But not yet to the consumer sector. The headline CPI rose 0.5% in March and +2.7% from a year ago. That's the largest increase since the year ending December 2009. Ex food and energy, the core rose only 0.1% and +1.2% from a year ago.

That is well below the Fed's target for core inflation. Inflation expectations, which Bernanke monitors very closely, fell last month. Expectations for the next five to ten years (figured by comparing different types of Treasuries called TIPS, against normal Treasuries, and covering the whole thing with special Fed sauce and whispering a few magic words) declined last month from an expected rate of 3.2% to 2.9%.

Lastly (for the moment) retail sales rose 0.4%. Bernanke and his cohorts on the Fed would say that, with high unemployment, there will be no wage demands to exert upward pressure on inflation. Therefore, continuing with QE 2 is the right thing to do and maybe even have a QE 2.5 (reinvest maturing Treasuries the Fed holds).

But, if food and gas are eating up the consumer paycheck, how can they spend enough on other things to encourage businesses to expand and hire more workers? I don't get how we are supposed to end this cycle.

And what I am fearing is that commodity inflation will be around for a while. Gasoline is over $4.00 in many sections of the country and corn and grains are near record highs. Cotton recently hit a 150-year high. Earth to Benny, earth to Benny, inflation is everywhere except at the Fed.

I also don't get how the Euro is going to hold together. If we looked at just Germany we would agree that a hike in their Fed Funds-type interest rate is called for. They came out of the recession very well (+3.6% first year GDP growth) and recent CPI/PPI reports have been above-trend.

But an interest rate increase strengthens the euro, and Ireland has significant business outside the Euro zone and Portugal relies on low-value, low-margin, labor-intensive industries, like textiles. A stronger euro could topple these economies. Greece's (remember them?) ten-year debt is trading at a 13% yield. Their two-year debt is over 17%. Portugal's ten-year debt is almost 9%, and Ireland's a bit worse than that. The credit markets are saying these economies are near death.

The prosperous northern European countries (they would add "fiscally prudent countries") rightfully worry about inflation. The annual headline rate for all the Euro zone was 2.7% in March, up from an annualized rate of 2.3% the month before.

The month-versus-month rate was 1.4%, the highest monthly jump on record since the euro was adopted. German inflation is a relatively modest 2.3%, but that is double the rate of a year ago. Portugal's inflation rate is 3.9% and Greece's is 4.3%.

The main culprits are food and energy in both areas (higher wages in Germany as well, and higher value-added taxes in Ireland, Portugal, and Greece as punishment for their sins). But it's mostly food and energy. Hear that, Ben? Food and energy, and Europe is acting on it. But the action favors one section and disadvantages another. Can they stay together?

To add to the mix, the True Finn Party did very well in the Finish weekend elections. It is possible that whatever coalition government is formed will vote against bailouts. All Euro zone members have to agree on the Portuguese bailout package or it's back to the drawing board.

I'll get back to the US budget battle, the Libya problem, with France and England complaining about being lonely in the fight, and the tumbling estimates for Q1 GDP (now below 2%, with quite a few at 1.5%) tomorrow. This is all I can take on a Sunday night. But, gee, the stock market just doesn't want to go down.

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