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Consumer data entered the fray last week to mixed results.  Personal income was up 0.3% in May, but concerns about the stagnating recovery resulted in no gains to personal spending.  With income and spending little changed, the personal savings rate also held steady at 5.0%.  The personal savings rate spiked in 2009, but fell after consumers were confident enough to dip back into their savings accounts. 

Concern about inflation is abating as well, after one-year-ahead expectations reached a peak of 4.6% in April.  In the most recent survey, consumers’ expectation of year-ahead inflation was 3.8%. 

 There is apparent strength in several areas of the economy.  Research from Fidelity Asset Management shows that while some key areas of the economy (housing and employment, in particular) are struggling, there are a number of positive data points.  Fidelity’s economic indicator scorecard shows strong and improving data in manufacturing, corporate earnings and capital expenditures. 

The final point to consider is that markets tend to perform best in the final two years of the presidential cycle. 

 From 1900 to 2009, year 3 and year 4 of the presidential cycle outperform years 1 and 2 by a wide margin.  In fact, average annualized performance in year 3 is 12.6% and year 4 is 7.5%, based on research from Ned Davis.

In our Monthly Economic report, we take an in-depth look at the changes in our markets and the effects of economic policy nationally and globally. This broader perspective provides greater clarity in understanding the forces that affect investment performance and future expectations. Click Here for report.

Barry Glassman moderated this morning’s conversation with David Rubenstein, billionaire, co-founder of the Carlyle Group, and one of the most world’s most successful business leaders. The event was held at the Willard Intercontinental Hotel in Washington, D.C. for over 475  attendees and Glassman Wealth Services guests.

Barry asked David a wide variety of questions ranging from his advice to solve the US debt crisis - David thinks that Congress is unable to tackle chronic issues and that it may take a crisis for them to act, to where he thinks inflation will go – David believes it’s headed up to 5%, but doesn’t believe it will rise to unbearable levels.   He joked that inflation won’t come anywhere close to the whopping 19%  that occurred when he was Deputy Domestic Policy Advisor for the Carter administration.

To answer Barry’s question about where to find opportunities in global markets, David thinks that China, Brazil and India are poised to have the most growth with China surpassing the US as the largest economy by 2035.

On a more personal note, Barry asked David about his acquisition of some very famous historical documents including copies of the Magna Carta, Emancipation Proclamation and the Declaration of Independence. David said that he purchased the documents as a gift to the United States for the opportuntities this country has given him. He also wants to share them with future generations so they will also know the importance of these timeless words in shaping of our nation.

Prior to the global financial crisis, many central banks were a misunderstood relic of the economic system. Since the crisis began, however, central banks became an integral part of the day-to-day functioning of the financial markets, and more broadly the economy. As we move past the financial crisis, central banks are in the unsavory role of unwinding support mechanisms while avoiding the throes of a new crisis.

By most measures, the recession is over. That is true in many respects, but the effects of the financial crisis are still being seen in numerous pockets around the globe, be it housing, labor markets or the European debt crisis. In order to combat the lingering hangover from our multi-decade credit binge, central banks, specifically the Bank of England (BoE), the European Central Bank (ECB) and the US Federal Reserve, actively sought to resuscitate the economy from its doldrums and to their credit, those efforts appear to have worked.

Emerging markets, on other hand, were largely unscathed during the crisis. Yes, there was a notable slowdown in growth, but the time to recovery was relatively short, and emerging market nations are already back on stable ground, with one caveat – inflation.

So, now what?

Central banks in the developed world are not yet ready to signal the all clear and begin tiptoeing away from the markets. There are indications that the exit is moving closer, but thus far, there are no definitive changes in policy. Following its early March policy meeting, for instance, ECB President Jean-Claude Trichet said that “an increase in interest rates at the next meeting (April 7th) is possible.”

According to the markets, though, at least one rate hike in the EU is a foregone conclusion, but US hikes are not likely to happen any time soon. In fact, there is less than an 8% chance that overnight interest rates will change by early August and a 26.0% chance of a rate hike by December. Those percentages are actually trending lower since the start of the year as traders grapple with a sluggish recovery and the realization that the Fed is in no hurry to change its stance.

The BoE is in a tighter bind than the US at the moment. Inflation in England currently stands at 4.4% over the past year, more than double the target 2.0% rate. At the March 9th and 10th monetary policy meeting, three committee members out of nine voted against holding rates at 0.5%. One committee member went as far as indicating that a 50 basis point (one basis point = 1/100th of 1%) rate increase was warranted.

Loose monetary policy in the developed world is making the situation in emerging markets more complicated by the day. Of the 21 countries in the MSCI Emerging Market index, the overwhelming majority are in the process of tightening monetary policy.

China, for example, is attempting to cool its economy by soaking up excess liquidity from its banking system. For the third time this year, the People’s Bank of China increased the bank reserve requirement ratio by 50 basis points to 20.0%. For every dollar deposited in Chinese banks, 20.0% is now required to be set aside at China’s central bank.

The difficulty in managing monetary policy for emerging market central banks is that food and energy costs represent a far greater outlay in those economies.

In countries such as the Philippines, food and energy is a more than 50.0% weight in its inflation index. For the largest emerging market economies, Brazil and Korea, in particular, food and energy is roughly 30% of inflation. By comparison, food and energy accounts for less than a 20.0% weight in the US consumer price index.

As pressure builds around the globe, it is important to remember the Federal Reserve’s mandate: “maximum employment, stable prices and moderate long-term interest rates.”  With domestic labor markets stagnating and consumer prices largely stable, there is no reason to suspect a suddenly aggressive policy mantra will be in the Fed’s future.  This will inevitably spill over into the emerging markets and create the possibility of new asset bubbles.  Central bankers in those emerging market economies are well aware of what is occurring. 

The global economy is more closely interwoven than at any time in history.  Managing rampant inflation and excess liquidity becomes increasingly difficult for emerging market central banks when their developed equivalents are hesitant to turn off the spigots.  Without a clear policy directive from developed nations, emerging market countries will likely be caught in a tumultuous cycle of inflation and asset bubbles.

The Lighter Side

While it is difficult to argue that inflation is officially a concern for the US, there is no doubt that inflation is heading higher. In each of the past three months, headline inflation – which includes the more volatile energy and food prices – exceeded economists’ expectations, the first time that this has occurred since May through July 2008.

What we definitively know is that there is a growing disparity between core and headline inflation measures, due directly to soaring food and energy prices.

Most of us may not realize, however, that when food prices are adjusted for inflation, the cost of food over the past decade was extraordinarily low, according to the International Monetary Fund.  In fact, real food prices are their lowest since the Great Depression. 

It only seems natural that a growing middle class in the emerging markets would demand more protein intensive diets, causing food prices to track higher.  This also means that food prices are unlikely to retrace any of their recent gains – essentially, we are facing uncomfortable food prices on a permanent basis. 

In a potentially troubling development, a number of corporate conference calls in recent weeks suggest that companies are ready to pass costs on to consumers in the second half of 2011 and into 2012, particularly in the retail sector.  Nike, for instance, indicated on a conference call last week that it will undertake “significant price increases across a broader range of styles” in 2012 – a direct result of growing production costs (labor and commodities, especially) in emerging markets.

The inflation story is not as simple as that, however.  In early March, BJ’s Wholesale Club stated that increased competition in televisions, tablet PCs and electronic readers is forcing prices down in electronic equipment.

Inflation is becoming a touchy subject around the globe as central banks debate whether prices are rising quickly enough to hinder global growth.  Consumers should be prepared for higher prices in many staple categories, such as retail and food. These industries are directly impacted by commodities and emerging market labor costs.  Producers were initially willing and able to refrain from passing costs along to consumers, but that phenomenon is about to come to an uneasy conclusion.

Based on all common measures, inflation is entirely nonexistent at this point in time. But if you ask the typical person how they feel, you might wind up with a very different response.

On Friday, we learned that the Consumer Price Index ticked up 0.1% in September for a 1.1% gain in the past 12 months.

Since consumer prices have stagnated, recipients of social security will not receive a cost of living adjustment (COLA) for next year, the second year in a row. Sadly, according to research from the Employee Benefit Research Institute, social security accounts for nearly 40% of the income for individuals 65 years and above.

What is not reflected in the most recent CPI figures, and the problem for those not receiving COLA adjustments is that the world is becoming a more expensive place in certain respects. Corn prices surged after the Department of Agriculture announced that corn production would fall 3.4% in 2010. Wheat is undergoing comparable pressure due to drought in Russia and dry weather conditions in the US Midwest, and cotton prices are now at their highest levels since 1870.

Producers, those who make the goods that we consume are experiencing higher production prices, up 4.0% over last year. Up to this point, producers have more or less been forced to “eat” higher commodity costs since they recognize that consumers are not in a position to pay significantly higher prices. However, relying on producers to continue subsidizing those costs is unrealistic.

Inflation is arguably not an issue for the time being, but with the Fed prepared to unleash trillions in additional liquidity, the outlook for inflation is more uncertain than ever. Investors and consumers alike should tread very, very carefully.

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