Inflation: What's next?

With the news of China's rate hike, the spectre of inflation is upon us again. We can certainly see that in commodity prices:

..and in bond yields:

Even Atlanta Fed President Lockhart (a non-voter) stated that "inflation anxiety is rising" when he looked at commodity prices and there is a disconnect between what central bankers consider to be inflation and what ordinary people consider to be inflation:

Yet inflation anxiety is rising. There seems to be a disconnect between what the Fed is saying and what people are experiencing when they fill up their gas tanks or read about rising food prices around the world. Over the last couple of weeks I've taken note of newspaper headlines. Here's a sampling: In USA Today, "Prices starting to creep higher"; in the Wall Street Journal, "Cost inflation puts a wrench into the works" and "Inflation fears replace other market worries"; in Fortune magazine, "How inflation is turning breakfast into a luxury item"; and just last Friday in the Journal, "Bernanke denies that Fed is stoking inflation." Are the Fed and the public on different planets?

I have always maintained that inflation is likely to show up as hard asset inflation, i.e. commodities, than in a rise in generalized price levels, as measured by CPI - which is watched closely by central bankers and the bond market. This dichotomy has the potential to create real distortions.

Fabius Maximus made a great point recently about this disconnect between hard asset inflation and CPI, or core CPI inflation [emphasis added]:

The Fed governors worry (like any sensible people) about the CPI flirting with deflation. Falling prices drives asset prices down. Worse, they drive down wages — while people’s debts remain fixed. That vise crushes the middle class (the poor don’t have debts; the rich have real asset wealth). But the Fed’s printing presses can prevent deflation (or at least severe deflation, if not necessarily Japan-style deflation-lite).

But the opposite condition is equally bad — and also looking more likely. Wages rising slower than prices. That’s death for the debt-heavy US middle class. The US is flirting with this today.

Central bankers believe that the inflation cycle is broken if wage inflation is contained. That just means that inflationary pain is borne disproportionately by the suppliers of labor compared to the suppliers of capital.

I have written extensively about the risks of widening the social divide. Should this continue, the best case is that America goes down the Argentinean road; the worst case can be found in places like Tunisia and Egypt.

Pick your poison.