Danger signals

US inflation: The combination of the latest U.S. consumer price index and industrial production statistics poses a warning. Inflation is convincingly positive, whether measured gross or net of food, energy and shelter. However strong industrial production and soaring commodity prices suggest price pressures will intensify, not decline, in future months. That risks pushing inflation high enough to rattle bond markets.

For several months until October, deflation theorists could point to the year-on-year decline in the CPI as evidence that deflation was a serious danger. With December's data, that argument is now threadbare. Since oil prices are now well above their levels a year ago, the energy component in the CPI has turned sharply positive, pushing the overall year-on-year rise in CPI to 2.7 per cent, close to levels that might cause concern.

The trick some economists use of excluding volatile food and energy prices from the index isn't currently working, either. The so-called core CPI rose 1.8 per cent last year, also making deflation seem a far-fetched fear. What’s more, stripping out the artificially calculated shelter component of the CPI — arguably just as valid as removing food and energy — the remaining “core core” CPI rose by 2.9 per cent in 2009, even closer to troubling territory than the headline CPI.

Meanwhile, industrial production was up 0.6 percent in December and has risen 4.7 percent since June, an annualized rate of 9.6 percent. Commodities and energy prices have also risen sharply, and continuing global monetary stimulus may push them up further. Thus even though consumer sentiment remains subdued, inflationary forces from a rapid manufacturing recovery and rising commodities and energy costs may push reported inflation higher rather than lower.

That could be important — especially for long-term bond markets, which are already anticipating heavy issuance by the US government to fund its deficit. Bond investors haven't taken fright yet, but a rise in consumer price inflation significantly beyond current levels could spook them, causing prices to drop and yields to spike. That looks to be more of a risk than any deflation.