The flood of borrowing in the U.S. is eventually going to force us to pay the piper, with some arguing that the bill may come sooner than later. Others have argued for continued deflation over the next 12-18 months (see previous post). Fortunately, or unfortunately, depending on your perspective, the move from deflation to inflation might not be as sharp as expected (see Bloomberg article). As it turns out, rising home vacancies across the U.S. are depressing rents, the largest item in the consumer price index released by the labor department. Home and apartment rents, as well as owners' equivalent rent, make up 30 percent of the CPI. As of the third quarter of 2008, the number of empty homes stood at 19 million, signaling that deflation may be here to stay for a while - or at least worries of inflation can wait until 2010, at the earliest. While not a perfect scenario, an environment with lower inflation will allow the Fed some extra time before it needs to start raising rates, thereby giving lower rates more time to do their magic without the threat of stagflation.

Some of the recent economic data and graphs from the St. Louis Federal Reserve look more like a ski slope or snow boarding run at the X-Games. In some instances the charts look truly scary, or encouraging, depending on the trend and your perspective. For instance, if you were worrying that the Fed was not doing enough to flood the system with liquidity (or worrying that it was doing too much), check out the recent Adjusted Monetary Base chart.

Source: St. Louis Fed

Are you thinking about re-financing, but not sure if rates are attractive? Check out the chart of conventional 30-year fixed mortgage rates.

Source: St. Louis Fed

Have you noticed that it does not cost quite as much to fill-up your car as it did just a few months ago? Check out the move in the energy component of the consumer price index.

Source: St. Louis Fed
Are you wondering whether the unemployment rate is really spiking, and how it compares to other recessions? Check out the following chart (the current loses are large, but not at historical extremes - meaning there is good and bad news - it is not as bad as it as been, but worse rates are not unprecedented).

Source: St. Louis Fed

Have you heard that we are moving from manufacturing to a service-based economy, but have been wondering just how long this has been occurring? Check out the number of manufacturing employees over the last three decades, and the last year.

Source: St. Louis Fed

Given the recent employment numbers in manufacturing and the general economy over the last year, it is not surprising that capacity utilization is falling off a cliff.

Source: St. Louis Fed

Wondering if other consumers have also been taking on extra credit over the last 20 years? Don't fear, you are not alone (well, maybe you should be fearful).

Source: St. Louis Fed

How have Aaa and Baa Corporate Bond Yields compared? The charts certainly seem to be reflecting some risk in the market (compare the two over the last year).

Source: St. Louis Fed

Source: St. Louis Fed

Finally, and even more disturbing, are the number of people that have been unemployed for 27 weeks or more. Given the spike up in extended unemployment, it is not surprising that home foreclosures are also increasing at a rapid rate.

Source: St. Louis Fed

Of course, I have focused on some of the more extreme charts, and even those pictures that truly are "worth a 1000 words" or more don't tell the entire story. Nonetheless, the last year has been interesting, even though some of trends have been in place for a while. While we marvel at the moves, it is also worth remembering that charts and series with such violent spikes or declines are often followed by similar extreme and violent reversals - although for some moves, such as in energy prices, you could argue that this is what we are currently seeing. Finally, I suspect that the picture being painted in each of these charts is far from compete in most instances. Whether we like it or not, the unintended consequences and fall-out from turning-on and then turning-off the liquidity faucet should provide additional topics for discussion months and years to come. Such moves will no doubt also create new challenges and opportunities.

There is an interesting article in the WSJ regarding recessions and productivity numbers. As seen in the figure below, the last six recessions have occurred at a time when productivity numbers were decreasing (although the numbers were still positive for the last two recessions, and productivity was relatively strong during the most recent recession in 2001).

Source: Wall Street Journal
While productivity has averaged 0.8% over the last six recessions, it is currently growing at an annual average rate of 2.5%. This is important since high productivity numbers allow the Federal Reserve to keep interest rates lower than normal since higher prices are being matched with higher productivity, at least to some extent. As an example, if workers are making x% more of a product in the same amount of time, then wages can increase by the same x% and the per unit labor cost will stay the same. Simplistic, but you get the idea. Productivity gains were the key to the 1990s, and one of the reasons Alan Greenspan was often espousing the benefits of high productivity, providing yet another reason to keep interest rates low, sub-prime notwithstanding.

Of course, higher productivity can allow you to keep from hiring new workers, or even allow you to reduce headcount, since now you can do more with less. Furthermore, the current high productivity numbers may just be an artifact of the recent environment. Housing, which is a less productive industry, is currently being shifted out of while higher productivity industries, like those exporting, are increasing in emphasis. The weak dollar is also having an effect in amplifying the export-based productivity numbers. Given that the U.S. is trading overseas more now than in the past, the higher export productivity numbers make sense.

So, if productivity is not cooperating for those talking recession, what about other numbers in comparison to previous economic conditions, such as the stagflation days of the 1970s that many analysts are comparing the current conditions to? Given higher energy costs, producer price increases for finished goods are worse now than during the 1970s, causing lower consumer confidence and higher levels of consumer credit as a percentage of GDP. The savings rate is down, as it has been for a while, and the number of vacant homes is increasing.

Yet, all is not bad, or falling off a cliff. The ISM index is hovering about the benchmark contraction / expansion levels, and disposal income has still not collapsed, even with increasing job losses. Industrial production, while flat, is also not severely contracting. Furthermore, core CPI (without food and energy) is not excessive, nor is core PPI. The unemployment rate, while rising, is also not yet close to approaching high single and low double digit levels. High productivity is keeping unit labor cost down (as discussed before), and wages have stayed in check for corporations. After-tax corporate profits as a percentage of GDP are also still good, and long-term Treasury yields are not excessive in comparison to the stagflation years.

So in short, is the picture rosy? No. But are we heading for another decade of stagflation with sustained lower growth and high inflation? Right now the data does not point to this conclusion, regardless of the continued comparisons. Housing and crude oil still seem to be ruling the day, the fallout of which is affecting nearly everything in the economy. When the former finally turns around, and the later sells off with conviction, we may be able to finally get rid of both the "stag" and "flation".

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.