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.
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
(Hat tip to a friend who pointed me to this article)
Under Alan Greenspan, the Federal Reserve was known to stand on the sidelines while bubbles in asset prices grew and grew. Greenspan had a lot more faith in the Federal Reserve’s ability to mop up the subsequent mess caused by a bubble’s collapse than in its ability to stop a bubble, much less identify one.
It seems times have changed. On October 13, Businessweek chronicled the Fed’s efforts to make sure that soaring prices in agricultural land do not lead to another messy bubble and economic calamity. Prices have indeed soared across the midwestern United States:
“The Kansas City Fed reported land values were 20 percent higher than a year ago. The Chicago Fed reported a 17 percent increase in its district, the fastest increase since the 1970s. Nonirrigated farmland in the Minneapolis Fed district increased 22 percent in price.”
The factors driving these increases are the same as I reported from a related Planet Money piece: “Land prices have doubled in Iowa over the past few years“: “elevated crop prices, soaring farm income, and record-low interest rates.”
As a result, nervous regulators are demanding rigorous stress tests of banks up to their gills in agricultural loans. Businessweek also reports that regulators are “…scrutinizing the lending standards, loan documentation, and risk management at the country’s 2,144 agriculture banks.”
I will be very interested in the outcome of all this scrutiny. The same Federal Reserve that helped create record low interest rates is working to ameliorate the impact of those very same interest rates. This episode is a reminder that flooding an economy with liquidity does not produce equal outcomes for all sectors. Recovery and prosperity does not even need to appear in the sectors most impacted by the malaise the Federal Reserve scrambles to repair. Instead, the money tends to collect where it will generate the highest returns due to other economic factors. Currently, it seems that the bet is on farming. I believe the Federal Reserve was aiming for housing…
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.
(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.”
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.