Thursday, February 18, 2010
The January Producer Price Index data released today should put finis to any notion that deflation is a risk. The headline number is up 5% over the past 12 months, and it has risen at a 9.8% annualized rate in just the past six months. Much of this perkiness is due to rising energy prices, of course, since the Core PPI is up only 1% in the past 12 months.
But before you say, "since core inflation is still well under control, there's nothing to worry about," let me make some important points.
The second chart is the PPI index plotted on a logarithmic scale. The white trend line shows that the PPI grew at a 1.2% annual rate from the early 1990s through 2002; this was a period during which monetary policy was generally tight, and by the Fed's own admission. Not surprisingly for us monetarists, inflation by all measures was well-behaved. Monetary was so tight, in fact, that gold and commodity prices fell from 1997 through 2002, and the dollar soared. Indeed, lots of people worried about deflation in the 2000-2003 period because money had been so tight in the years prior.
Since 2003, however, which is when the Fed decided that monetary policy needed to be kept very easy for a very long time in order to avoid the risk of deflation, inflation by all measures has picked up. The red trend line shows that the PPI grew at a 3.3% annual rate from mid-2003 through mid-2009. And as I mentioned above, the PPI has grown at almost a 10% rate in the past six months. Since 2003, gold and commodity prices have soared, and the dollar has collapsed, further confirming that monetary policy has been quite easy for the past seven years.
If monetary policy were tight enough to prevent inflation from exceeding, say, 1-2%, that would not necessarily preclude a huge rise in oil prices. But it would mean that if oil prices rose a lot, then there would be a lot of downward pressure on other, non-energy prices, since on average prices could only rise 1 or 2% a year. That's not the case currently, however. Although core PPI inflation has moderated somewhat since 2008, it is still positive and it has grown at a 3.3% annual rate in the past three months. My point is that if money were tight, then a big rise in energy prices should have produced at least flat, if not falling non-energy prices. But it hasn't.
Bottom line: monetary policy is loose, and it shows. Deflation is not even remotely a threat, despite the huge "slack" in the economy (the amount by which the economy is growing below its potential). The Fed has been running monetary policy based on a flawed theory of inflation. Price pressures are significantly higher than the Fed's model would suggest. They are making a mistake, and they need to get on the tightening bandwagon sooner rather than later.
This same analysis should also tell the economic recovery skeptics that they have been too pessimistic. If deflation is no longer even remotely a threat, then the downside risks to the economy are greatly reduced. Plus, even if the Fed were to start raising rates tomorrow, they are already behind the curve. It would take a LOT of rate hikes for a long time before monetary policy could be considered a threat to economic growth. It makes more sense to worry about inflation than it does to worry about the economy these days.
Posted by Scott Grannis at 9:33 AM