Core Inflation on the Rise: Are Paul Krugman and Other Deflationists Wrong?

There are different measures of inflation. There is the headline measure of inflation and core inflation. Headline inflation takes the price of food and energy into account, while core inflation does not. Headline inflation is a measure of what economic agents feel in the economy on a day-to-day basis. Paying more at the pump, for example, is headline inflation. The Federal Reserve takes inflation into account when deciding on decisions of monetary policy. However, the Fed generally ignores headline inflation in favor of the core inflation measure. This is because the rate of headline inflation can vary wildly over time, often unrelated to general economic trends. For example, if a hurricane in the Gulf of Mexico destroys an oil refinery, and the price of gasoline rises, headline inflation may rise as well. Of course, it does not seem wise for the Fed to shift its monetary policy based on the destruction of an oil refinery. Core inflation is insulated from these short-term price swings, and is thus generally agreed to be a better measure of the inflationary trend. Since the Fed began its asset purchases, many economic pundits have warned that an expanding money supply would eventually lead to massive inflation in the U.S. economy. That inflation finally arrived last year, in the form of massive increases in the price of commodities like oil and gold. However, other commentators such as Nobel Laureate Paul Krugman have argued that this inflation is temporary, as core inflation has remained subdued. The Fed's Chairman Ben Bernanke has largely echoed this view. On Tuesday, Krugman published a post on his New York Times blog in which he stated, "We're likely to see a negative headline inflation number by June. What will the inflationistas say? Of course, all this is why we need something like core inflation, so as not to overreact to short-run fluctuations." Is it time to overreact then? For the month of May, core CPI rose 0.20%. Annually adjusted core CPI is now running at 1.50%, a number which surprised most economists, according to iMarketNews. Is an increasing core inflation number evidence that the "inflationistas" have been right all along? Action Items Bullish: Traders who believe that inflation is starting to become a real problem in the broader U.S. economy might want to consider the following trades:

• Buy SPDR Gold Trust GLD in a long play on the yellow metal. Gold has traditionally done well in periods of inflation, as traders seek safety in the limited supply of gold.
• Buy Teucrium Corn Fund CORN in a long play on U.S. exports and commodities. If inflation is ravaging, commodities like corn may appreciate in price. Also, inflation may depreciate the value of the U.S. dollar, thereby making American exports like corn more attractive to foreign consumers.

Bearish: Traders who believe that the rise in core CPI is transitory may consider taking positions in the following:

• Power Shares DB US Dollar Bullish Index UUP is a long play on the U.S. dollar. With limited inflation, the dollar might appreciate in value.
• ProShares Short Dow 30 DOG is a short play on the Dow Jones. If there is minimal inflation, asset prices like stocks may not rise, in fact they may decline, which might be good for a short Dow ETF like DOG.

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