Stagflation? No. Sagflation? Yes.

There is increasing discussion of the risk of stagflation developing in the economy, making the decisions of the Ben Bernanke more difficult. The argument for stagflation misses the underlying cause of recently rising CPI prices. Namely, higher commodity prices and rising medical costs. Indeed, breaking down the most recent CPI numbers shows that energy prices increased 19% y/y and food prices increased 4.2% y/y. These prices are a direct result of rising oil and certain food commodity prices. However, it should be noted that oil prices have been declining and thus inflationary pressure exerted by oil should begin to slacken. Similarly, commodity food prices have begun to roll-over, also providing inflationary relief.

The core CPI, excluding energy and food, increased 1.8% y/y. This rise is hardly in the danger zone. Broken down further the number reveals its drivers of vehicle sales (used vehicle prices up 5.3%) and medical costs (up 3.2%). The rising vehicle prices likely moderate since there remains excess capacity in the supply chain for cars and trucks and we'll see what happens to medical costs as "ObamaCare" begins to get implemented.

The CPI is a historical looking number and is largely impacted by changes in prices that occurred months beforehand since it takes time for rising commodity prices to work their way through supply chains into higher prices to consumers. Therefore, investors relying on CPI to make investment decisions risk driving while looking in the rear view mirror.

The thesis of sagflation, on the other hand, appears very much intact. I have defined sagflation as weak economic growth due to high levels of debt and structural inefficiencies in the economy, combined with more volatile prices due to aggressive actions taken by the Federal Reserve. In April I argued that deflation is the greater risk going forward, and I continue to believe this argument. In June I argued about the risks of deflationary pressures "taking the legs" out of the economy, which I believe has been happening.