U.S. heading for inflation increase

America’s rate of inflation could hit 4% by next fall, thanks to rising food prices and increased global energy demand, according to a new report from CIBC World Markets.

Avery Shenfeld, senior economist with CIBC World Markets, says the U.S. Federal Reserve Board will likely ignore the reasons for the inflation rate, and instead continue focusing on the core consumer price index.

But excluding food and energy from the inflation numbers doesn’t work in today’s world, explains Shenfeld. In the past, unpredictable gas and food prices meant that the Fed could get a more accurate inflation reading by excluding these two factors. But now, food and gas prices are determined by four longer-term trends and likely won’t rise and fall quite as rapidly as they have in the past.

One of these trends is insatiable energy demand by developing countries. The rapid energy consumption from the likes of China and India has stretched energy supply and helped oil prices reach record-breaking levels.

As well, energy price increases, combined with the faltering American dollar, is widening the country’s current account and trade imbalance, while high energy costs are getting passed on to consumers and business through items like airline ticket prices and trucking costs.

Finally, more ethanol production has affected food and gas prices, as more resources are devoted to growing corn, pushing up feed grain prices in the process, which have, in turn, forced meat, dairy and egg prices to increase.

Shenfeld expects that the Fed will cut rates to spur on the economy and that improvements will begin late next year. But a rate cut, combined with rising gas and food prices, will also bring on the 4% inflation rate.

“If, as we expect, this proves to be no worse then a mid-cycle slowdown, the economy won’t open up enough slack to materially change the trajectory for inflation when better growth resumes in the second half of 2008,” Shenfeld says. “As a result [of the inflation rate moving to 4%], the Fed may be rushing to re-tighten rates before year-end 2008.”

If that happens, Shenfeld says, U.S. treasuries, and likely Canadian bonds, could be in dire straits. “The biggest impact is on investors in the U.S. bond market, which will be a troubled place when it awakens to the faster uptrend in inflation,” he says.

He does add that U.S. treasury inflated protected securities (TIPS) could fare well, as they are tied to overall CPI. “TIPS will outperform treasuries to the extent that inflation exceeds the implicit projection over the life of the bond, or to the extent that spreads widen as inflation expectations change.”

Because of Canada’s strong currency and the GST cuts, Shenfeld does not expect Canada’s CPI to top 2.5% in 2008.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com