Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber.
I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.
Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:
“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”
This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.
The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve
Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:
“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”
Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….
The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve
The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:
“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”
This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.
I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.
So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…
To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.
Full disclosure: long GLD, SLV.
I continue to think it makes more sense to fear inflation than deflation, but I cringe when I read “inflationists” who continue to over-state the case for inflation. Two recent pieces that appeared in Project Syndicate are case in point: “When Inflation Doves Cry” by Allan Meltzer and “The Ghost of Inflation Future” by Brigitte Granville.
Allan Meltzer wrote “A History of the Federal Reserve” and is considered an expert on the Federal Reserve. He wrote recently to complain about a cover story in the Wall Street Journal that declared victory for the inflation doves over the hawks. Meltzer essentially called the doves lucky. He insisted that the lack of inflation despite the Federal Reserve’s massive growth in its balance sheet was something no one on either side of the divide predicted. I actually seem to recall plenty of deflationists from 2008 to this very day who have scoffed at the notion that the Fed can do anything to stop an eventual deflationary collapse. So, I think Meltzer is too broad in trying to excuse himself for being wrong all these years about the immediate inflationary consequence of quantitative easing (for Meltzer’s dire warnings on inflation early in the crisis see his 2009 interview on EconTalk).
Even more problematic for me is that Meltzer calls on the Federal Reserve to stop paying interest on reserves, the very thing that is containing the kind of increase in the monetary supply that will surely boost inflationary pressures. Meltzer also seems to imply that the Fed should simultaneously raise interest rates and work down the reserves on the balance sheet. These two prescriptions strike me as deflationary. I suppose there is some formula whereby all these can be done in a harmony that can spur non-inflationary growth and avoid deflation, but Meltzer does not make it specific. (It is also possible that the strict limits on article length in Project Syndicate made it impossible for him to clarify).
In 2010, Mletzer wrote in the Wall Street Journal that eventually banks would start loaning out the money currently held in reserves. The only reason to do this would be if banks felt they could make more money than simply accepting the free money from the Fed. Meltzer did not say what would motivate such lending except to suggest that the Fed would get the rate on reserves wrong. Now, three years later, to advise that the Fed drop the rate altogether is to ask for a free pass to make a prophecy come true.
Mind you, I am sympathetic to the case that says the Fed will not be able to contain inflation when it finally starts up again, but the specific mechanism for a reignition of inflation is still not quite clear yet in my opinion. The Fed seems inclined to maintain an accomodative stance well into an economic recovery in order to ensure that the recovery has firm roots. That bias is certainly the seed from which inflationary pressures can (will) grow…but we need that recovery first!
Brigitte Granville wrote “Remembering Inflation” which makes the case for establishing inflation targets as a tool for maintaining the inflation-fighting credibility that central banks need to foster stable prices (see summary at Princeton University Prcess). In her piece on Project Syndicate she concludes by warning that Europe will soon go from depression to high inflation. It is a bewildering prediction given she acknowledges that the European Central Bank cannot raise its inflation target, and its program of “outright monetary transactions” must be accompanied with tight fiscal policies. In many ways, the ECB is acting as if it fears inflation more than deflation. Moreover, Granville notes that as a consequence heavily indebted nations in the eurozone will eventually be forced to restructure their debt with creditors (instead of attempting to inflate away the debt with a devalued currency). Without a devlation in the currency, I have a hard time understanding how such restructuring will trigger inflation. Instead, it is likely to make it even more difficult for borrowers in these countries to access the credit markets, sterilizing an important inflation-generating mechanism.
We inflationists have been premature and even wrong on our inflation expectations. Here on Inflation Watch, I finally acknowledged back in June that it was time to cool my inflation expectations. I still promise to maintain vigil and write related pieces, but it just does not make sense to write in such expectant tones…at least not until something fundamentally changes in the inflation picture. In the meantime, inflationists would do well to avoid predictions of inflation until they (we) can specifically describe exactly how (and when?) the inflationary threat will manifest itself. The odds for an imminent inflationary spiral are NOT 100%, probably not even 80%…
Things have been pretty quiet around here. Every now and then I see a story about rising prices somewhere in the world and think the story would make a great quick post for Inflation Watch. However, I usually do not feel the same sense of urgency I had from 2008 through about 2011 when I felt that rapid inflation was the imminent result of extremely accomodative monetary policy. Everywhere I look, commodities continue to decline in price. Most commodities reached a peak in 2011 and that peak of course had me convinced more than ever that inflation was soon to be a big problem.
Now, thanks to a friend, I am ever closer to accepting that inflation may not be a problem for an even longer time than I expected. He sent me a link to an article called “The Fed won’t taper as long as inflation is low” (by Rex Nutting at MarketWatch) that makes the convincing case that not only is inflation low, but the Federal Reserve has so far seemed powerless to generate the inflation it wants. (I recognize the limitations of government data on inflation, but I do not subscribe to theories that they are concocted specifically to hide true inflation). Incredibly, core inflation is apparently at its lowest point since 1959 (the core PCE price index):
Nutting also links to a paper from the Federal Reserve Bank of New York called “Drilling Down into Core Inflation: Goods versus Services.” In this paper, authors M. Henry Linder, Richard Peach, and Robert Rich demonstrate that more accurate inflation forecasts come from breaking out CPI into a services and a goods component. Nutting uses this as reference for the claim that the Fed is failing because of global disinflation. This global disinflation is responsible for a decline in the prices of the goods component. Services inflation is much more sensitive to domestic forces (we all know about skyrocketing healthcare and education costs). However, I am not sure where housing sits on this spectrum. It seems to provide a crossroad of forces given housing is not tradeable but foreigners are certainly free to overwhelm a housing market with cash. Foreign demand is reportedly helping to drive up housing prices in some of America’s hottest housing markets like in California and some parts of Florida.
All this to say that, for the moment, inflation is all but dead. But “Inflation Watch”, this blog, is NOT dead. I remain vigilant because I believe that when inflation DOES come, the Federal Reserve will either be ill-equipped to handle it and/or unwilling to snip it early for fear of causing a severe economic calamity. I am a gold investor, and I am eager for another chance to invest in the midst of a commodity crash (I am LONG overdue for an update to my framework for investing in commodity crashes/sell-offs).
The chart below from the Reserve Bank of Australia (RBA) shows that commodity prices remain at historically high levels, mostly thanks to rapacious demand from China. The current relative decline is what is helping to drive goods inflation down. The 2011 peak was well above the pre-crisis peak where prices have fallen now. Also note that prices are much more volatile. I suggest that this chart should remind us that commodity prices are a tinder box that can flare up at anytime. Aggressive rate-cutting by the RBA should also help keep prices aloft.
So stay tuned. Just when everyone finally concludes that the world has reached a golden age of disinflation where surpluses abound across the planet…that could be the exact moment the tide turns.
Be careful out there!
Full disclosure: long GLD
Land prices have doubled in Iowa over the past few years. The team at Planet Money conclude that the land boom throughout the agricultural U.S. Midwest is being driven by “real” economic forces. They identify low interest rates, grain traders, and government subsidies for ethanol as key drivers of this boom. Low interest rates are enabling land purchases. Grain traders and the demand for ethanol are driving up corn prices which in turn make land for growing corn more dear. Starting with auctions in Iowa, Planet Money takes us to a part of the country that is booming while much of the rest of the country is stagnating.
Finally, one “seasoned farmer” warns that this boom is indeed a bubble and points to the crash in land prices in the 1980s after a similar period of exuberance.
Listen to “The Tuesday Podcast: The Land Boom“
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):
- Monetary policy can be adjusted to accommodate the extra volatility in headline inflation by, for example, focusing on year-over-year changes.
- 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.
- 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.
- 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.
On June 15, Bank of England Governor Mervyn King spoke at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. The speech covered very familiar themes for King and the Bank of England.
King begins by acknowledging the squeeze on the current economy:
“The challenge facing monetary policy is obvious – the combination of high consumer price inflation and weak economic growth. Both of these might seem surprising given the large amount of spare capacity in the economy. But the rise in world energy and other commodity prices, and the need to reduce both the external and budget deficits, are squeezing real living standards, pushing up on consumer price inflation and slowing domestic consumption.”
Over the years, King has consistently hammered on the theme of rebalancing in the UK’s economy: a transition away from domestic consumption and toward exports and the business investment required to support this shift. King indicated that the rebalancing underway will continue for several more years. This process has necessitated the devaluation of the currency. Interestingly, King cleverly attributes the devaluation to market forces while indicating the Monetary Policy Committee (MPC) chose not to counter-act the pressures on the currency:
“A necessary precondition for that rebalancing was a fall in the real exchange rate. Markets anticipated that need. The nominal effective sterling exchange rate fell by around 25% between the start of the crisis in 2007 and the beginning of 2009, since when it has been broadly stable…
…We could have raised Bank Rate significantly so that inflation today would be closer to the target. But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits. And it would have meant a weaker recovery, or even further falls in output…”
In other words, the MPC decided to focus on the implications of a weak economy over the implications of high inflation, judging the former to be the greater threat. In doing so, King has frequently noted that today’s high inflation is temporary, thus rationalizing on-going accomodative monetary policy and low interest rates in the face of high inflation. The primary blame for high inflation has shifted from hikes in taxes (the Value Added Tax or VAT) to commodity and energy prices, both presumably out of the control of monetary policy. Internally, conditions do not exist for sustaining “domestically generated” inflation:
“So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course. Banks are still contracting balance sheets and reducing leverage. Spreads between Bank Rate and the interest rates charged to many borrowers remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all.”
King really caught my attention when he provided two key conditions that would actually compel rate hikes:
- A pickup in domestically generated inflation
- A contraction in the spreads between Bank Rate and the interest rates charged to many borrowers
Given the dour outlook for the economy and an on-going reblancing in the economy, I continue to assume that rate hikes in the UK are somewhere off in a very distant future. King has proven quite adapt in coming up with reasons for maintaining loose monetary policy, and I continue to see strong evidence that he is reluctant to tighten for fear it could upset the rebalancing he so deeply desires. Indeed, King notes that there is no way to tell when the MPC may hike rates:
“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer price inflation on tomorrow’s domestically generated inflation. So it is simply impossible to know now at what point monetary tightening will begin.”
(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)Posted: May 31, 2011
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.”
Nightly Business Report produced a short video segment describing China’s inflation woes (transcript included) called “China’s Inflation Battle.” The commentator identifies China’s RMB¥ 4 trillion stimulus program (about $585B USD at the time) as the original source of the inflation and takes us to Pengshui, 1000 miles from Beijing, to see some of the examples of how inflation is impacting the lives of the average Chinese person.
The most interesting quote came from Associate Professor Patrick Chovanec of Tsinghua University, School of Economics and Management:
“When you see over 50 percent growth in the money supply, the question isn’t, why is there inflation? The question is, why isn’t there more inflation? Why haven’t we seen it sooner? The reason is because a lot of that money didn’t go into a consumption boom. It went into an investment boom.”
It is a scary thought to think inflation problems could (will?) get even worse once the Chinese figure out how to make use of all this massive investment.
CNBC reported on a study from Clear Capital titled “Clear Capital Reports national Double Dip“:
“Home prices have double dipped nationwide, now lower than their March 2009 trough…a surge in sales of foreclosed properties and a big push by banks to facilitate short sales…[forced] home prices down dramatically. Sales of bank-owned (REO) properties hit 34.5 percent of the market, according to the survey, resulting in a national price drop of 4.9 percent quarterly and 5 percent year-over-year. National home prices have fallen 11.5 percent in the past nine months, a rate not seen since 2008.”
CNBC goes on to indicate that the foreclosure problem has spread beyond just the “bubble” markets that were at the center of the housing crisis:
“…the mid-west is seeing a surge in REOs now, thanks to the plain old recession. 40 percent of the Chicago market is foreclosures, 43 percent in Cleveland and 51 percent in Minneapolis. Home prices fell 8.7 percent in the Mid-West during the past three months compared to the previous quarter.”
It is once again important to note that housing was one of the big targets of the Federal Reserve’s dollar-printing campaign. Given that housing prices have not responded while commodity prices have soared, we must now wonder whether the Fed believes it simply did not print enough, whether there is a longer time lag than anticipated to seeing an impact in housing, and/or worry about the unintended consequences that have yet to be seen. The money had to go somewhere; so far, it has not been into housing.
In “Beijing turns to currency to cool inflation“, the Associated Press gives a good summary of China’s current problems with inflation, including the following:
“Economists blame China’s inflation on the dual pressures of consumer demand that is outstripping food supplies and a bank lending boom they say Beijing allowed to run too long after it helped the country rebound quickly from the 2008 global crisis.
Attempts at price controls, subsidies for the poor and orders to local leaders to guarantee adequate vegetable supplies have had mixed results.”
The failure to control inflation to-date is forcing China to allow the currency to appreciate faster. The near-term increases still seem modest at 5% (against the dollar), so it will be interesting to see whether China continues pushing harder on non-currency methods.
China’s currency is not traded on open markets, but if it were, it seems the currency would soar given current conditions.
CNBC reported that “Adjusted For Inflation, Dollar Hits Fiat-Era Low.” Economists at Deutsche Bank calculated the value of the dollar on a trade-weighted basis and then made adjustments for inflation. Their conclusion is that the dollar is at its lowest point since the U.S. went off the gold standard under President Richard Nixon.
The full article is worth a read but here is a key quote:
“The recent parabolic spike in silver and to a lesser degree gold, shows that the market considers a ‘disorderly decline’ of the U.S. dollar an increasing possibility…”
Gold also looks to continue higher. According to a recent article in Bloomberg:
“Central banks that were net sellers of gold a decade ago are buying the precious metal to reduce their reliance on the dollar as a reserve currency, signaling demand that may extend a record rally in prices.”
Disclosure: author owns GLD, PAAS
Time for some comedic relief. On my main site “One-Twenty Two” I posted my own satirical commentary on the recent announcement from Attorney General Eric Holder about the formation of the Oil and Gas Fraud Working Group. This taskforce is supposed to ensure prices properly reflect “real” supply and demand factors from the marketplace. In my post, I ponder what the story would look like if Holder decided to go after the Federal Reserve’s role in generating higher oil and gas prices (mainly through killing the U.S. dollar). Click here to read it.
And now for a different perspective…
In CNBC article “Data Double Take: Inflation for Majority of Economy at Record Lows“, David Rosenberg, chief economist & strategist at Gluskin Sheff, argues that inflation is not a threat in the U.S. because the service sector’s rate of inflation is at historic lows. Moreover, companies in the service sector have no pricing power and workers are unable to earn higher wages. These arguments all run counter to other findings demonstrating that CPI from any angle is pointing to inflation in the near future.
The most interesting claim in the article is that the Federal Reserve’s printing press is, in effect, churning out fresh dollars at no cost:
“The Fed may be printing money, but it’s not multiplying through the economy like it once did. That’s because banks are not using it to extend credit, said the economist. Also, our economy has generally become more resistant to the Fed’s reflation powers because of productivity gains from technology and globalization, the doves say.
‘The money multiplier has been broken for quite some time, and recently it is going lower,’ said Brian Kelly, of Brian Kelly Capital, citing money supply data that for every $1 pumped into the economy only 76 cents is being created. ‘In effect, monetary policy has been losing its potency for 30 years. What the Fed is doing now is stepping on the gas while the tires spin in the mud.'”
I would love to see more data on that because over those same 30 years the Federal Reserve’s monetary accommodations have been credited with creating shallow recessions before 2008, averting a complete financial meltdown in the last recession, and, most recently, driving stocks on a 30% rally since late summer of 2010. Of course, easy money from the Federal Reserve has also been blamed for assisting and outright creating the our triple bubbles in tech stocks, housing, and credit.
It seems that one’s inflation expectations often hinge on the imagination: either you believe the generally accepted inflation data as indicative of a tame future inflation outlook, or you look at specific (even pervasive) examples of inflationary pressures as warnings of what is to come. I have clearly been in the latter camp.
I am two months late on this one.
In February, Bill Fleckenstein refuted the notion that inflation is a net positive in “No such thing as good inflation.” He starts by noting how higher prices in commodities are driving inflation expectations upward:
“As unprecedented amounts of liquidity from the Federal Reserve have worked their way through the financial system and into the real world, I believe inflation psychology has changed. People have seen larger price increases in commodities and are resigned to accept them, which will set the stage for additional rounds of price hikes.
Once that psychological shift becomes entrenched, it will be extremely hard to reverse, despite Fed Chairman Ben Bernanke’s stated certainty that he can keep prices under control…”
Fleckenstein goes on to insist that as long as the Federal Reserve is allowed to play free and loose with the dollar, deflation will not happen in America:
“I would like to officially declare the topic of deflation dead. As I have long maintained, we may actually experience deflation if the bond market rebels and takes the printing press away from the Fed. However, in the absence of that, it should be clear by now that deflation is not going to visit the shores of America.”
I made a related point back in October, 2008. Back then I thought we would see elevated inflation levels no later than 2010. Regardless, Fleckenstein provides to a great reminder that inflation is, and has always been, the threat once the Federal Reserve started throwing freshly printed bills at our economic calamities.
With so much heated debate and discussion about inflation in the media these days, I thought I would focus on how the Federal Reserve discussed and debated inflation in the latest meeting minutes released today.
The Federal Reserve’s staff economists concluded that while commodity prices have increased substantially and near-term inflationary expectations have also increased, the outlook for medium and long-term inflation remained stable. In other words, current inflationary pressures should prove “transitory.”
“Sizable increases in prices of crude oil and other commodities pushed up headline inflation, but measures of underlying inflation were subdued and longer-run inflation expectations remained stable…
…According to the Thomson Reuters/University of Michigan Surveys of Consumers, households’ near-term inflation expectations increased substantially in early March, likely because of the run-up in gasoline prices; longer-term inflation expectations moved up somewhat in the early March survey but were still within the range that prevailed over the preceding few years.
…Measures of inflation compensation over the next 5 years rose, on net, over the intermeeting period, with most of the increase concentrated at the front end of the curve, likely reflecting the jump in oil prices. In contrast, measures of forward inflation compensation 5 to 10 years ahead were little changed, suggesting that longer-term inflation expectations remained stable.
…The staff revised up its projection for consumer price inflation in the near term, largely because of the recent increases in the prices of energy and food. However, in light of the projected persistence of slack in labor and product markets and the anticipated stability in long-term inflation expectations, the increase in inflation was expected to be mostly transitory if oil and other commodity prices did not rise significantly further. As a result, the forecast for consumer price inflation over the medium run was little changed relative to that prepared for the January meeting.”
Some Federal Reserve members expressed their concern that current inflationary pressures may still lead to upward pressure on long-term expectations:
“…participants observed that rapidly rising commodity prices posed upside risks to the stability of longer-term inflation expectations, and thus to the outlook for inflation, even as they posed downside risks to the outlook for growth in consumer spending and business investment.”
InflationWatch has chronicled numerous instances of companies that either plan to or already have passed on price hikes to consumers. The Federal Reserve is also noticing, but their “contacts” are apparently not confident that plans for price hikes can stick:
“A number of business contacts indicated that they were passing on at least a portion of these higher costs to their customers or that they planned to try to do so later this year; however, contacts were uncertain about the extent to which they could raise prices, given current market conditions and the cautious attitudes toward spending still held by households and businesses.”
I often whether in these circumstances whether the Federal Reserve passes on some “friendly” advise to these contacts…
The most common reason cited for assuming inflation will remain tame is that there remains a large amount of slack in resource utilization in the economy. Someone on the Fed recalled an important exception to such assumptions:
“Some participants pointed to research indicating that measures of slack were useful in predicting inflation. Others argued that, historically, such measures were only modestly helpful in explaining large movements in inflation; one noted the 2003-04 episode in which core inflation rose rapidly over a few quarters even though there appeared to be substantial resource slack.”
One way to keep inflation expectations anchored is to insist that it will stay anchored. Ben Bernanke has planned to do press conferences, and the rulebook assurances over inflation may be part of the motivation:
“A few participants noted that the adoption by the Committee of an explicit numerical inflation objective could help keep longer-term inflation expectations well anchored.”
Finally, the topic of the Federal Reserve’s balance sheet came up. I have long maintained that the Fed will find itself unable to wind down this balance sheet quickly or in a timely fashion. Some on the Fed are afraid that more people like myself will harbor these same doubts:
“…a few participants noted that if the large size of the Federal Reserve’s balance sheet were to lead the public to doubt the Committee’s ability to withdraw monetary accommodation when appropriate, the result could be upward pressure on inflation expectations and so on actual inflation. To mitigate such risks, participants agreed that the Committee would continue its planning for the eventual exit from the current, exceptionally accommodative stance of monetary policy.”
This path toward an exit is likely fraught with monetary perils and should provide a lot more volatility in financial markets. Stay tuned.
In “China inflation may hit 6 pct, no end to tightening -paper“, Reuters reports that the official China Securities Journal insists fighting inflation is the number one job for monetary authorities. Given a consumer price index hitting 32-month highs in March and likely to rise as high as 6% this year, China will continue to hike rates to thwart these inflationary pressures.
Yesterday, China’s central bank increased interest rates for a fourth time in six months.
Charles Evans, President of the Chicago Federal Reserve, recently spoke at The Darla Moore School of Business giving “A Perspective on the Current Economy.” The press summarized the lecture by indicating Evans remains a “dove” on inflation:
“The Fed is more sanguine about inflation than some because an outbreak of higher prices is missing a key ingredient – higher wages, Evans said…A weak labor market will continue to exert important downward influences on inflationary pressures, he said.” (from Marketwatch)
A cynical person could say that Evans does not fear inflation because QE2 has failed to provide the one single thing that Americans care most about in the economy right now: jobs. Instead, I will note that this commentary comes immediately on the heels of an op-ed piece from Laurence H. Meyer, a former governor of the Federal Reserve, who opined that inflation is not a problem…and even if it became one, the Fed would quickly get it back under control. Since the Federal Reserve cares more about inflation expectations than current levels of inflation, it makes a lot of sense that a good amount of energy is spent trying to convince people that no matter what the data say or the anecdotal evidence (or Inflation Watch postings for that matter!), the future is fine.
However, the Wall Street Journal noted that the commentary from Evans runs directly counter to the warnings of coming inflationary pressures from FOMC voting member Charles Plosser, president of the Philadelphia Federal Reserve Bank (see here). Apparently, the gameplan and script are not receiving the same reading on the team!
Laurence H. Meyer, a former governor of the Federal Reserve, wrote an op-ed in the New York Times titled “Inflated Worries” in which he confidently argues that inflation expectations remain well-contained and even if they became unhinged, the Federal Reserve is ready to respond quickly:
“The Fed, this argument goes, just won’t be able to act quickly enough to turn off the spigot when the time comes to do so.
But the Fed can raise interest rates directly any time it wants. In addition, it could start to sell the huge volume of Treasury securities and other financial assets on its books, which would also place upward pressure on rates.
Would the Fed act in time? I expect that it will. And even if it doesn’t act in time, and inflation expectations start to get out of line, I am confident that the Fed would tighten monetary policy quickly and aggressively enough to restore price stability and maintain its credibility on inflation. You can take that to the bank.”
Meyer’s unspoken assumption in this piece is that unemployment would not be so high that it discourages the Federal Reserve from acting. Ben Bernanke has made it abundantly clear that unemployment is front and center and that the growing concerns about inflation around the globe are not his or America’s concern. So, I remain extremely doubtful that the Federal Reserve is unconditionally prepared to act in the face of rising inflation expectations.
Meyer also explains in his piece the difference between core and non-core (or headline inflation). He disabuses the audience of the notion that higher food and energy prices increase inflation expectations citing Federal Reserve research that “…unequivocally tell us that core inflation better predicts overall inflation tomorrow” (see “Estimating the common trend rate of inflation for consumer prices and consumer prices excluding food and energy prices“). However, Meyer blithely ignores the study’s conclusion that this relationship did NOT hold during the 1970s and 1980s: “In the 1970s and early 1980s, movements in overall prices and prices excluding food and energy prices both contained information about the trend.” In other words, there is little in this study to suggest that the relationships are stable.
Ultimately, I think those who argue that there are fundamental, structural pressures that indicate increasing energy and food prices are reflective of inflation’s future direction, especially once supply constraints finally show up in more sectors of the economy, will prove to be the most prepared for the future. In other words, today’s food and energy inflation has been an early outcome of easy money policies because supply constraints and demand dynamics are most readily exploited in these sectors of the global economy right now. (I made a related argument when discussing the recent rapid increase in coffee prices).
Hopefully through inflation watch you have been able to note the growing pockets of inflation pressure and the increasing power companies have to raise prices at least at the producer level…
The Swiss National Bank (SNB) has been extremely reluctant to increase interest rates, presumably because its currency has been excessively strong. Meanwhile, its forecast for near-term inflation has increased, and the economy has performed reasonably well despite the strong currency (although tourism and exports have recently suffered a bit).
The pressure to increase rates may have ratcheted up a notch with Anne Heritier Lachat, the chairwoman of the Swiss Financial Market Supervisory Authority (FINMA), complaining about the potential for housing bubbles in Switzerland. Lachat cited in an interview that all the key ingredients for a bubble exist: low rates, demand exceeding supply, and the assumption that housing has once again become a safe investment. The direction of SNB monetary policy could get a lot more exciting from here…