Friday, May 28, 2010

Inflation remains tame, but the future remains uncertain

News from the inflation front continues to be quite benign, despite the numerous signs of rising inflation pressures that I have been citing since early last year. This chart shows the headline and core measure of the Personal Consumption Deflator, arguably the most comprehensive measure of inflation at the consumer level, and also the Fed's favored indicator of inflation. Some years ago the Fed established a range of 1-2% for this indicator, and by this measure inflation has been within its target range for the past 18 months. Prior to that, however, inflation was consistently above its target from 2004 through 2008. Over the past 5 years, the PCE deflator has risen at a 2.2 annualized rate, while the PCE core deflator is up at a 2.0% annualized rate; so when viewed from a long-term perspective, the Fed is finally on the verge of getting things right.

Ordinarily I would cheering this news. After all, from a supply-side perspective low and stable inflation is of paramount importance, since it provides a fertile field for confidence in the currency and for the investment that fuels growth and job creation. However I continue to be concerned about the potential for rising inflation, if for no other reason than the fact that monetary policy is in totally uncharted waters given the massive expansion of bank reserves in the past 20 months. Traditional indicators of monetary error such as gold (up 370% in the past 10 years and inches from a new all-time high), the value of the dollar (only 5% above its all-time low in inflation-adjusted terms relative to a large basket of currencies), real interest rates (the real Fed funds rate is negative), and the yield curve (still historically steep), suggest that at the very least the Fed is erring on the side of ease, and they have been very upfront in admitting this.

So while the official inflation numbers are almost as good as one could hope for, one's confidence in the future behavior of inflation cannot be very high. There is a lot of uncertainty surrounding the inflation picture, and that is not good. Thus, I consider monetary policy to be acting like a headwind to the economy, keeping growth from being as robust as it otherwise might be. Fiscal policy is another headwind, sapping the economy's strength by redistributing money from the most productive to the least productive.

Most of the supply-siders I know share these views. Interestingly, they run completely counter to the views expressed by many mainstream economists, who see fiscal and monetary policy as important sources of stimulus. So important, moreover, that they worry terribly that the economy is effectively on life-support and could not survive even the slightest reduction in monetary or fiscal stimulus. If nothing else, it's fascinating how reasonable people can take diametrically opposing views of the facts and come to similar conclusions: namely, that while the economy is recovering, we are unlikely to experience a robust recovery, and there are many reasons to worry. And that's why I think that we are still in a bull market, because true bull markets always have to climb one wall of worry after another. Optimism is in short supply.


John said...


I can understand the argument that government spending is 'bad money buying' and that it transfers productive spending to less productive spending but I have a more difficult time getting how raising interest rates now would be stimulative. The market people I know are all using the fed's low interest rate policy as a reason the economy will continue to expand. It would be virtually an unexpected shock for the fed to hike now and IMO would immediately send the stock market to new lows for the year and perhaps even a retest of the March '09 lows. Commodity prices would also be hit.

I know you continue to worry about inflation but the market is worried about DISinflation. The fear is another fall in economic activity not an economy heating up. I know the numbers are pointing to a continued expansion both in the US and global economies but there are still serious disinflationary headwinds out there and more shocks are seen as reasons to increase the probabilities for an economic rollover.

If and when the fed raises rates I really think some serious prepping needs doing before the fact.

Scott Grannis said...

Raising interest rates is not necessarily stimulative, but interestingly, it is the case that the American consumer benefits on net from higher interest rates than from lower interest rates. That's because households have more floating rate assets than floating rate debt.

Regardless, when the Fed raises rates it will be a confirmation that the economy is doing better. It would take a huge increase in rates to slow the economy. Before that happens, higher rates will calm the fears of a Fed mistake, and they will help build confidence in the dollar. Combined, this will help boost investment and growth in the future. Doing the right thing (raising rates above zero) can never be a bad thing for the economy, in my view.

There are plenty of examples throughout history of high interest rates and strong growth coexisting. That's not surprising at all. Japan's extremely low interest rates have obviously not helped its economy, have they?

John said...

I think the market wants to see more evidence of sustained growth before they are willing to see a fed on the inflation warpath again. I believe that growth will come and the fed will need to raise rates but I think confidence is still too fragil for them to begin soon. I agree that if they prep it well, a rate hike can signal their confidence that the economy is improving and the process needs to begin. As for the consumer, disinflation is protecting him from any pain of being in cash. I think it is going to be a long time before they back to the equity market and many will never return.

I wish I understood the Japanese situation a little better. From the little I know their policy responses to their banking problems were different from ours. I'm not sure we are a good comparison.

Thanks for the comment. Have a great Memorial Weekend!

skydude said...

"That's because households have more floating rate assets than floating rate debt."

I would like to hear more about that comment. Is that because more households hold more monetary assets as opposed to mortgages (and the like)?

BTW: I love this blog! I am currently a graduate student in economics, working as a professional pilot (which I have been doing for a long time, ugh!)

Rob said...

Scott, re. optimism in short supply: what do you think about the "pessimistic" view that governments are tapped out and no longer able to bail out anyone, including themselves, therefore we may stand on the precipice of much greater market falls even than at the start of 2009. There is no more cavalry to ride to the rescue.

Scott Grannis said...

skydude: If you look at the Fed's calculation of Household balance sheets

you will see that the majority of financial assets held by households are in the form of deposits, and the interest rate on deposits will rise if the Fed tightens. Furthermore, the vast majority of household debt is in the form of 30-yr fixed rate mortgages. So households are clear beneficiaries, on net, of rising interest rates.

Rob said...

Scott, of course you have no obligation to answer questions from readers. You did so very dilligently in my case and I was grateful and impressed. Then I seemed to do something wrong by asking you a bit too persistently for your views on Cable and currencies, and you stopped answering. I assume my latest question above also fails to merit an answer. My comments re. AAPL share price were deemed worthy of your attention. I think my latest question, above, is worthy of a reply, so please I humbly submit it again.

Scott Grannis said...

Rob: your pessimistic view would be my optimistic hope: that governments stop trying to bail us out. Government "stimulus" spending only results in a greater debt burden and a less efficient economy. Bailouts of failing banks only creates more moral hazard and makes markets less efficient. Government bailouts set dangerous precedents. I hope we live to see the day when governments become powerless to help.

Rob said...

A fascinating and stimulating answer, as ever, Scott, many thanks. btw, I am reading the book u recommended, Panic: The Betrayal of Capitalism, so thanks also for that. Perhaps almost as interestingly, I am reading it as an e-book downloaded via kindle to my iPod. I think we are at a "tipping point" re. e-books and it is a wonderful thing - of course it should have happened long ago, way before digital music, but such is the power of vested interests and inertia.

Scott Grannis said...

I'm on my third book on the iPad and agree that this is sure to be a bigger part of our lives going forward. One thing however bothers me: how can you share a good book with a friend?

Rob said...

I think if the economic model was right then sharing would not be so much of a problem because it would be cheap enough for your friend to buy his own copy.

The costs of e-books are so much lower in terms of distribution - no more paper and print and no more physical transportation. If the book industry stopped acting like a cartel then we could all just enjoy infinitely more availability at much lower prices. I bought your book recommendation in the wee small hours of the morning and was reading it within about a minute or so of paying for it on my iPod.

PS - I haven't yet got an iPad but I am more than happy using my iPod for reading e-books because A) I always have it with me and B) using a slightly larger typeface it is very comfortable to read at arm's length. in fact, C) I think that I read more and more easily when there is a small amount to read on each page !

PPS - At the risk of overloading you Scott, I wonder if you could explain this strange grammatical idiosyncracy I keep seeing in the "Panic" book: the authors seem to conflate the personal pronoun (I) with the accompanying verb, so that, for example, "I am" becomes "Iam" or "I want" becomes "Iwant". Iwonder if this is an American habit because Iam not aware of it in the UK ?

Frozen in the North said...

After all the money the government has spent, the U.S. economy is still not exhibiting inflationary pressures. That worrying! The sad reality is that the U.S. economy is in a deleveraging process, companies are generating profits, but sales are down or flat, that means cost compression. In 2009, the total amount of debt (private and public) fell for the first time in 20 years. Despite the best efforts of Obama and his government the U.S. borrwings fell in 2009. THe model America needs to be worried about is Japan, where corporation (starting in 1990) began an aggressive program of debt reduction.

Only one outcome -- deflation (it was around 3% last year).

Scott Grannis said...

Rob: I suspect the "Iam" you're seeing is a artifact of the eBook publishing process. I did not see this at all in the print edition I read. I have seen errors like this in other eBooks.