Last week a number of readers asked me why investors were buying long-dated U.S. Treasuries. My response was: Why not? Tell me from where inflation is coming. This shocked my inquisitive readers as they have been bombarded with warnings of rising rates and building inflation pressures. Even the Fed has described low inflation conditions as transitory. The official Bond Squad view has been and continues to be: The ice age was transitory too, but it lasted a heck of a long time. Simply stated, low inflation pressures could be with us far longer than the Fed or many economists believe.

What is the catalyst for lowflation? The most obvious source of lowflation is energy prices. The energy boom (with capacity financed by low-rate-induced malinvestment) is the most visible source. However, that is just one source. Technology, globalization and demographics are also helping to keep inflation pressures low. The stronger U.S. dollar is helping to keep prices of imported non-energy goods and services lower too. Even when petroleum is removed from the Import Prices data, prices of goods imported to the U.S. fell 3.7% (YoY) last month. Until we see a weakening of the U.S. dollar, it is unlikely we will see inflation move far into positive territory. If the dollar stabilizes, Import Price inflation could move up to 0.0%, but much beyond that is unlikely unless the Fed eases again or foreign central banks tighten monetary policies. I would file that under “unlikely” for the next year or two (or three).

There is some hope that when the year-over-year price change for oil and other commodities fade, headline U.S. inflation should rise. There is some truth to this, but how far might it rise? Some financial industry professionals believe that when the year-over-year oil price decline fades, both headline and core inflation could rise. However, logic and past performance do not support that theory.

Headline PCE YoY vs. Core PCE YoY since 2010 (Source: Bloomberg):

As you can see, Core PCE (core inflation) has been far more stable than Headline PCE (headline inflation). This is not surprising as headline inflation is subject to volatile food and energy prices. You can also see that headline inflation tends to converge with core inflation more than it pushes it higher or pulls it lower. Thus, it is more likely that when energy prices cease declining year over year, or even begin rising, it is more likely that headline inflation converges with core inflation rather than pushing it higher. To get both core and headline inflation to or above the Fed’s target of 2.00%, the U.S. dollar probably has to weaken significantly versus major foreign currencies and/or we need one heck of a growth/consumption spike. Once again history (viewed in its proper context) offers guidance.

Headline PCE YoY vs. Core PCE YoY since 2010 (Source: Bloomberg):

As can be plainly seen, the only times the Fed’s favored measure of inflation (Core PCE YoY) breeched 2.0% during the past 20 years were 2004 through 2007. Not even during the Tech Bubble of the late 1990s was Core PCE YoY able to average above 2.0% on an annual basis. Even during the 2004-2007 Housing Bubble core inflation struggled to get past 2.25%. Why the Fed appears so confident that 2.0% Core PCE is on the way is beyond me.

If you are wondering what was driving Headline PCE above 3.0% in 2007, the following charts explain it.

DXY U.S. dollar index vs. major foreign currencies (Source: Bloomberg):

Price of WTI Crude Oil 2004 through 2007 (Source: Bloomberg):

Hmm? Notice the correlations. A weaker dollar helped to push oil prices higher which, in turn helped to push headline inflation higher. However, even with a plunging USD, soaring oil prices and ripping headline inflation, core inflation reached the lofty height of 2.32%. That’s right. It took a major economic bubble just to get Core PCE to 2.32%. Do any of you see conditions materializing even remotely similar to this? I sure don’t.