Inflation Washes Ashore

Ever since the election of Donald Trump as U.S. President, the stock market has gone into a “Trumpflation” mode of trade. The early evidence of inflation may have finally washed ashore.

U.S. January prices rose 0.6% and core prices rose 0.3% month-over-month. Both were slightly higher than expected, and the rise was the highest since February, 2013. Year-over-year the Consumer Price Index (CPI) rose 2.5%, the highest since march, 2012. The CPI incorporated some particularly strong price hikes:

“Clothing prices jumped 1.4 percent, the most since February 2009. Men’s apparel surged by the most on record. New vehicle prices climbed 0.9 percent in January, the biggest advance since November 2009.”

The price hikes were enough to push real hourly wages down by 0.5% form December and unchanged year-over-year.

This is just one month of data, yet it precedes any of the policy changes or fiscal stimulus measures which promise to introduce inflationary pressures into the U.S. economy. InflationWatch is officially back on alert for the U.S.!

Bullard recommends targeting monetary policy at headline, not core, inflation

The Federal Reserve Bank of St. Louis just published an article written by James Bullard, a non-voting member of the Federal Reserve and President of the St. Louis Fed, called “Measuring Inflation: The Core Is Rotten.” It is based on a speech Bullard delivered two months ago to the Money Marketeers of New York University. It is a refreshing perspective on the use of core inflation for guiding monetary policy; it is also a bit surprising coming from someone on the Federal Reserve!

Bullard starts and ends with a critique familiar to those of us who insist food and energy prices should not be excluded from measures of inflation:

“One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Federal Reserve with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy…

…The headline measures of inflation were designed to be the best measures of inflation available. It is difficult to get around this fact with simple transformations of the price indexes. The Fed should respect the construction of the price indexes as they are and accept the policy problem it poses. To do otherwise may create the appearance of avoiding responsibility for inflation…”

(Compare and contrast this to Governor Frederic S. Mishkin’s insistence in 2007 that the Federal Reserve should care about headline inflation but focus on controlling core inflation in its public stance on monetary policy.)

I love the recognition that average consumers and businesspeople “know price changes when they see them.” This is Inflation Watch’s reporting philosophy and helps explain my emphasis on reporting the price changes of a broad range of products and services.

Bullard makes some key points to argue that headline inflation can and should be the focus of monetary policy. While I agree with his overall thesis, I do take issue with some of the points (my comments in bold):

  1. Monetary policy can be adjusted to accommodate the extra volatility in headline inflation by, for example, focusing on year-over-year changes.
  2. The relationship between core and headline inflation is unclear and even changes over time, making it more difficult to comprehend the optimal policy response. Me: This was an interesting point since the Federal Reserve’s statements usually imply the Federal Reserve tunes policy for core, not headline, inflation anyway. Currently, Ben Bernanke has all but absolved monetary policy of any impact on commodity prices.
  3. The Federal Reserve cannot directly influence supply and demand dynamics for any particular product in the inflation index, so it is not sufficient to ignore prices that are supposedly out of the Federal Reserve’s control. Me: I understand Bullard’s point, but I also think providing cheap money that traders can easily borrow to bid up the prices of goods and services is a strong and sufficient influence. The Federal Reserve definitely thinks it can directly influence housing demand and prices given its targeted efforts at lowering mortgage rates.
  4. When the price of one good goes up, another goes down as consumers adjust their demand to stay within their budgets. Increasing food and energy prices can thus force other prices down in the core index and further understate true inflation.

Bullard further notes that their is promising research into directing monetary policy at a specific subset of prices that households care most about, but it is too early to use.

Of particular interest to me was Bullard’s identification of a changing world where commodity prices will join the prices of medical care (and education) in outpacing the overall average inflation rate.

“…much of the contemporary worry about commodity prices is that relative price changes may be much more persistent going forward than they have been in the past…

…it is at least a reasonable hypothesis that global demand for energy will outstrip increased supply over the coming decades as the giant economies of Asia, particularly India and China, reach Western levels of real income per capita. If that scenario unfolds, then ignoring energy prices in a price index will systematically understate inflation for many years.”

(See “Preparing for Profits in a Resource-Constrained World” on implications for investing).

Given the limitations and blind spots of core inflation, Bullard makes a convincing case for directly targeting headline inflation with monetary policy. Otherwise, the Federal Reserve remains at risk for maintaining monetary policies that are too loose for too long.

Changing the measure of inflation to generate more government revenue

I read a short article in Planet Money that reminded me why I tend not to pay attention to official government inflation statistics. The government estimates it could generate $200B in extra revenues over a decade by making the switch. This reminds me that the folks generating the index essentially have a vested interest in the numbers themselves or at least can face political pressures to calculate and/or interpret them in ways favorable to policy.

See “The Wonky Inflation Tweak Worth Over $200 Billion” for more.

Asian inflation may finally be cooling

Thanks to improvements in crop production, monetary tightening, a slowdown in economic growth rates, and currency appreciation, the trend now appears to be heading down for core and headline inflation in Asia. Different countries are wrestling with different problems, but, overall, economists and analysts quoted in “Food Inflation Begins to Moderate in Asia” seem to be getting optimistic about the prospects for inflation.

The article includes some statistics on the huge difference in price trends on various food items in India:

“The cost of bananas in New Delhi is up 50 percent over the year, while paneer – a form of cottage cheese – has risen 26 percent to 145 rupees per kg.

Yet other food prices are falling. Staples such as tomatoes and potatoes, which peaked earlier in the year at levels that caused great stress to poorer families, have seen prices moderate in recent weeks.”

The Federal Reserve May Choose to Ignore the Inflation Expectations of Households

(Originally appeared in “One-Twenty Two“)

First, Bernanke made it clear he thinks gold is not a good indicator of inflation expectations. Now, the Federal Reserve Bank of San Francisco has produced research that could convince the Fed to insulate itself from the inflation expectations of average Americans in “Household Inflation Expectations and the Price of Oil: It’s Déjà Vu All Over Again” by Bharat Trehan (thanks to Bill Fleckenstein for calling this article to my attention).

Household inflation expectations have risen to 4.5% from 3% at the end of 2010. Fortunately for the Federal Reserve, its empirical research seems to show that household expectations have become inaccurate and irrelevant for monetary policy:

“This Economic Letter argues that the jump in household inflation expectations is a reaction to the recent energy and food price shocks, following a pattern observed after the oil and commodity price shocks in 2008. The data reveal that households are unusually sensitive to changes in these prices and tend to respond by revising their inflation expectations by more than historical relationships warrant. Since commodity price shocks have occurred relatively often in recent years, this excessive sensitivity has meant that household inflation expectations have performed quite badly as forecasts of future inflation.”

Trehan admits that the University of Michigan’s Survey Research Center shows that households had been pretty good indicators of future inflation from the 1970s to 2000. However, over the past several years, the increased volatility in the prices of food and energy have misled consumers to anticipate more future inflation than is warranted given low levels of existing core inflation:

“The recent jump in the Thomson Reuters/University of Michigan measure of household inflation expectations appears to be related to increases in the prices of energy and food, similar to the jump observed in 2008. The size of this response to noncore inflation cannot be justified in terms of the historical relationships in the data. This disproportionate response is probably the reason why household inflation expectations have not done well as forecasts of future inflation in recent years, a period of volatile food and energy inflation. The poor forecasting performance argues against reacting strongly to the recent increases in household inflation expectations.”

Moreover, recent increases in inflation expectations are not justified by changes in monetary policy. Trehan speculates that…

“It’s also possible that households’ sensitivity to noncore inflation goes up following substantial, sharp increases in the price of energy and food items, such as those that occurred in the 1970s and over the past few years…This similarity to the 1970s is unsettling because it suggests that consumers are not accounting for the ways monetary policy has changed over this period.”

I assume this claim means that the Federal Reserve’s monetary policies have improved since the 1970s. In my opinion, we have seen even less reason to trust in the Federal Reserve’s policies to the extent that these policies “fix” economic problems in such a way to help set up the next crisis. These crises build while the Federal Reserve tends to reassure that it has everything under control and/or there is nothing happening to cause concern.

I would challenge the historical record and related regressions to suggest we need to consider whether the structural underpinnings of inflation are changing in ways that the Federal Reserve will be slow to recognize. Whether the Federal Reserve can do anything about these changes is another question.

A danger of inflation: The misallocation of resources on the way to sustained price increases (an explanation of the mission of Inflation Watch)

In January of this year, Professor Russ Roberts of George Mason University invited fellow economics professor Don Boudreaux to address “Monetary Misunderstandings” on the weekly podcast “EconTalk.” From the synopsis:

“Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.”

I was most interested in the discussion about the definition of inflation because I understand the importance of maintaining technical and economic clarity on this topic for “Inflation Watch.”

Boudreaux first deferred to Milton Friedman’s famous empirical proclamation “inflation is always and everywhere a monetary phenomenon” and lamented that the economics profession no longer defines inflation as an increase in the money supply. Now, inflation represents a sustained increase in the average price level in the economy. Inflation is not simply any increase in price; Boudreaux complained that this definition is a common misconception of non-economists. However, he acknowledged that he personally thinks inflation’s largest threat is the process by which price increases become sustained. This process features uneven injections of money into the economy, causing specific and identifiable distortions in the economy that lead to a misallocation of resources. (Roberts somewhat disagreed as he expressed much greater fear of hyperinflation).

Bill Fleckenstein first taught me this notion that increases in the money supply distort specific areas of the economy. Such distortions can morph into bubbles, inflation’s ultimate misallocation of resource (capital). Bubbles can occur without ever tipping the economy into an inflationary cycle via official government statistics. So, it is very easy, for example, for the Federal Reserve to do nothing about soaring prices in an important sector of the economy and instead simply plan for the ultimate clean-up of the bubble’s aftermath. In recent history, the disastrous wakes of bubbles have forced the Federal Reserve to resort to easy money policies that invariably help fuel the next bubble. (Fleckenstein famously reviews this process and a lot more in “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.”)

Through Inflation Watch, I identify news of price increases not because any one price hike defines inflation; as noted above, this approach is technically incorrect. Instead, these stories offer clues that potentially can uncover the misallocations of capital that flag inflationary forces may be developing. I am trying to piece together a mosaic of economic activity that may provide early indicators of inflation well ahead of the moment that government statistics show it or the moment the Federal Reserve officially announces an inflationary process is underway.

The general context is important. We are currently experiencing an extended period of easy money policies in most of the globe’s developed economies. Presumably, this money must go “somewhere” at some point in time. Financial markets are the perfect conduit for easy money; investors and speculators alike will flock to those parts of the economy that promise some protection against the devaluation of currency and/or profits from inflationary pressures. (Boudreax and Roberts never directly addressed the enabling influence of financial markets for transmitting inflationary pressures). I have argued in previous posts that the most favorable hosts for easy money are where demand is particularly robust and supply may be constrained or stressed. Today, commodities represent a perfect storm for global easy money policies. So, many of the recent stories in Inflation Watch have focused on commodities and industries dependent on consuming commodities.

The Federal Reserve’s current bias toward inflation shows because the Fed has demonstrated relatively quick action to thwart the perceived threat of deflation. The specter of the Great Depression always looms large. Recall that after the dot-com bubble burst, Greenspan cited the threat of deflation as a prime reason for aggressively loosening monetary policy. The crash of the housing bubble of course generated an even more aggressive policy of monetary easing given housing’s importance to the overall economy and consumer spending. The Federal Reserve’s recent success in averting deflation certainly adds confidence in applying easy money policies, much to the likely chagrin of devout deflationists. Meanwhile, the Federal Reserve has also made it clear that it will not act against inflation until price increases (or the expectation of price increases) reach sustained levels over time.

For example, last week, Bloomberg quoted Federal Reserve Bank of Chicago President Charles Evans in “Fed’s Evans Says ‘Slow Progress’ in Economy Justifies Maintaining Stimulus“:

“Inflation is a continuing increase in the price level over time: A one-off increase in the price level is not inflation…Price increases have to be sustained.”

I duly noted that at no time does someone from the Federal Reserve insist that deflation is a continuing decrease in the price level over time!

Evans goes on to express his comfort with the current levels of inflation by citing empirical research showing no correlation between higher oil prices and inflation. Even a casual examination of the current record of price increases demonstrates that oil’s price rise is just one small part of the general increase in prices percolating in the economy, especially where demand is strong and supply is compromised. Regardless, the conclusion of this research is intuitive given the numerous supply-related fluctuations in oil that have occurred with and without Fed monetary action. As we saw above, it is not likely that the increase in prices in any one part of the economy will produce the sustained increase in price levels required to signal inflation’s arrival. Without an increase in the money supply, increases in oil prices steal money from some other products in the consumer’s basket of goods. The net impact on official inflation statistics may be close to zero and “core” inflation, subtracting energy and food, could even decrease! But if increases in the money supply happen to coincide with a strengthening oil market, I contend we better look out.

The bias of the Federal Reserve toward inflation is also rooted in the concept that “a little inflation” is good for the economy because it encourages spending. Specifically, inflation encourages consumers to buy today to avoid paying higher costs tomorrow. In a deflationary environment, consumers just wait and wait and wait. Boudreaux and Roberts sharply criticize this theory and cite examples demonstrating the fallacy of such thinking. For example, with even a little inflation, why don’t sellers just wait until tomorrow to sell since they can make higher profits? Why do consumers buy computers and many other electronic goods knowing full well that prices will be lower tomorrow (not to mention these goods will be of higher quality)? Why was America’s post-Civil War economy so strong for almost 30 years despite persistent deflation? Clearly, buyers and sellers are motivated not just by relative prices, but also the relative value (or utility) gained from consumption and/or alternative investments.

I have covered the core concepts reviewed by Boudreaux and Roberts related to the philosophy and approach of “Inflation Watch.” If you want more detail, I highly recommend listening to the podcast, reviewing the transcript, and/or perusing some of the references provided by EconTalk. Hopefully, you have also gained a better understanding of Inflation Watch’s mission: “Watching for inflation here, there and everywhere.”

Finally some “inflation” in Japan

It had to happen eventually…Japan’s core CPI finally experienced some year-over-year lift. In “Japan Core CPI Rises First Time Since 2008“, Reuters reports:

“Japan’s core consumer prices rose in April from a year earlier for the first time in more than two years as the impact of school tuition fees faded and commodity costs crept up, but underlying prices remained weak as the March earthquake hurt consumption…

…A government policy to subsidize school tuition fees is no longer distorting annual changes in prices, as more than a year has passed since the policy was introduced. The move was estimated to have pushed down overall prices by about 0.5 percent.”

OK. So this lift is not likely to last given the special adjustment, but it is a nice break from the regular drone of deflationary news. As I have stated before, I tend not to pay much attention to official government statistics on inflation, but this headline alone made me pause. The rest of the article summarizes the prospects for Japan’s post-disaster recovery economy.