The New Inflation Problem

In 1980, inflation at the consumer level (the Consumer Price Index) was running above 14 percent.

The situation was so bad that then-Fed Chairman Paul Volcker had declared war on inflation and was raising interest rates every time you turned around. The problem was that inflation had risen from under two percent in 1965 to nearly 15 percent in 1980. Thus, the CPI was in an uptrend that did not appear to have an end.

The "Inflation Problem"

Granted, with the Fed on the warpath, the "inflation problem" did abate in relatively short order and by 1986, the CPI bottomed out at an annual rate of 1.1 percent. Problem solved, right? Unfortunately though, the 1.1 percent rate seen in 1986 was the low-water mark for the next fifteen years.

And during that span, the CPI oscillated up and down, and was "a problem" several times from the late 1980's through early 1990's. Then just before the credit crisis took hold in 2008, inflation was once again "a problem" as the CPI moved back above 5.5 percent.

The Fed's target for the CPI is right around two percent. Inflation problems occur when the CPI moves above the three percent mark or so.

However, there is an awful lot of talk these days about a new kind of inflation problem - as in not enough. That's right, after worrying about the vagaries of runaway inflation for the past 40+ years, the members of the FOMC are now worried that the economy doesn't have enough inflation.

On several occasions FOMC members have talked about this new inflation problem. Heck, just yesterday, St. Louis Fed President James Bullard suggested that the Fed wouldn't make a move until inflation perked up a bit. The Committee would not normally remove policy accommodation in an environment where inflation is below target and is projected to remain there, Bullard said.

If this sounds a little off kilter, join the club. After all, lots and lots of smart folks continue to fret that the Fed's current ZIRP (zero interest rate policy) and QE programs are sure to spark a serious bout of inflation in the future. And as history has shown, once inflation starts to roll, it can be tough to stop.

Ben Bernanke's Concern

However, Mr. Bernanke appears to be more concerned about the other type of inflation problem - deflation. While the 50-year chart of the CPI only has one brief blip where the annual rate of change was negative (during the credit crisis, the annual rate of change for the CPI went to -2.1 percent), Gentle Ben appears to remain steadfast in his desire to keep the good ol' US out of a Japanese-style deflationary spiral.

Given that the Japanese economy has been plagued by deflation since 1989, Bernanke knows that once deflation sets in it can be even harder to stop than the so-called runaway inflation seen in the U.S. during the 1970's. He has a point. The Fed has proven that it CAN choke off inflation by hiking rates.

However, up until Abenomics was put into effect this year, Japan had tried throwing everything but the kitchen sink at the deflationary spiral, all to no avail. (For the record, Abenomics calls for throwing the kitchen sink, the cabinets, and the counter tops at the problem this time.)

In the old days, one had to read between the lines of whatever the Federal Reserve said (remember the days of the Greenspan "briefcase indicator?"). There weren't statements accompanying rate decisions, press conferences, or the never ending stream of open mic sessions we have today.

The Fed Chairman didn't do interviews on "60 Minutes." To be sure, the current Fed is by far the most transparent ever. However, the lip service being paid to the idea that inflation is currently too low might just turn out to be a smoke screen.

While this may be just an opinion, it appears that all the talk about inflation being too low is "cover" for the FOMC to continue to pump money into the U.S. economy. You see, up to this point, Mr. Bernanke has erred on the side of caution with regard to economic stimulus.

Each and every time Europe's crisis interrupted the fragile recovery, the Bernanke cavalry would mount up and ride to the rescue. It appears that Mr. Bernanke isn't about to change his stripes at this point in time. Especially now that he knows he will have a new job come next January.

Delayed Taper?

IF (note the use of all capital letters) talks about inflation being "below the Fed's target" or further discussions of deflation continue, this may represent justification for the Bernanke Fed to avoid taking their proverbial feet off of the gas pedal too soon. So, IF the data continues to come in mixed AND IF that is correct, the new inflation problem might mean that the much ballyhooed QE "taper" could begin later than currently expected.

Current Market Drivers

Success comes from understanding the driving forces behind the market action on a daily basis. The thinking is that if one can both identify and understand why stocks are doing what they are doing on a short-term basis; it is unlikely one will be surprised/blind-sided by a big move. Listed below are some of the driving forces of the current market (listed in order of importance).

1. The State of Fed/Global Central Bank Policies 2. The Outlook for the U.S./Global Economy 3. The State of Unrest in Egypt/Middle East

The State of the Trend

It is important to analyze the market using multiple time-frames. Short-term is 3 days to 3 weeks, intermediate-term is 3 weeks to 3 months, and long-term is 3 months or more. Below are the current ratings of the three primary trends:

Short-Term Trend: Moderately Negative (Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Positive (Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive (Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the limportant levels to watch today:

Near-Term Support Zone(s) for S&P 500: 1680
Near-Term Resistance Zone(s): 1710

The State of the Tape

Momentum indicators are designed to determine the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of indicators relating to the market's "mo"...

Trend and Breadth Confirmation Indicator: Moderately Positive
Price Thrust Indicator: Positive
Volume Thrust Indicator: Neutral
Breadth Thrust Indicator: Neutral
Bull/Bear Volume Relationship: Positive
Technical Health of 100 Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus one must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

Overbought/Oversold Condition: The S&P 500 is moderately oversold from a short-term perspective and is low neutral from an intermediate-term point of view.
Market Sentiment:The primary sentiment model is negative .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help identify the current environment, look to the longer-term State of the Markets Model. This model is designed to determine when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model determines whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Moderately Positive - The weekly model is positive. This suggests to continue to favor the bulls.

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Turning To This Morning...

Overnight in Japan, politicians put a damper on expectations for a cut in corporate taxes. Such talk has led to weakness in the dollar/strength in the yen, which is not friendly to the yen-carry trade. In response, traders are selling U.S. stock futures this morning. This, combined with another spike higher in interest rates has pressured key technical levels in stock futures and put the bears in charge in the early going. Thus, look for a weak open on Wall Street and for sellers to try and break the current trading range to the downside.

Pre-Game Indicators

Here are the Pre-Market indicators to review each morning before the opening bell...

Major Foreign Markets: - Japan: -2.11% - Hong Kong: -0.01% - Shanghai: -0.86% - London: -1.04% - Germany: -0.65% - France: -0.39% - Italy: +0.48% - Spain: -0.09%

Crude Oil Futures: +$0.64 to $107.49

Gold: +$3.10 to $1336.50

Dollar: higher against the yen, lower vs. euro and pound.

10-Year Bond Yield: Currently trading at 2.756%

Stock Futures Ahead of Open in U.S. (relative to fair value): - S&P 500: -10.49 - Dow Jones Industrial Average: -86 - NASDAQ Composite: -27.05

Thought For The Day...

"A fool thinks himself to be wise, but a wise man knows himself to be a fool." -Shakespeare

Wishing you green screens and all the best for a great day,

David D. Moenning Founder and Chief Investment Strategist StateoftheMarkets.com

Positions in stocks mentioned: none

Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them in the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision System Can Help

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

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