Inflation update—still tame, but still a concern

If you don't believe that the Bureau of Economic Analysis is staffed by professionals that do their best to measure inflation accurately, then this post is not for you. I've been working with the BEA's numbers since 1980, and I have never managed to turn up evidence of gross or chronic error in their numbers. It's fashionable to say that the government is systematically understating inflation, but as the Boskin Commission found, the CPI, for example, may actually be overstating inflation (the CPI is calculated by the Bureau of Labor Statistics). I've compared the CPI to the broader and better-calculated personal consumption deflator (shown above), and to me it looks like there is indeed a case to be made that the CPI overstates inflation as measured by the PCE deflator by maybe as much as 0.5% per year over time. But that's relatively small potatoes. The PCE deflator is arguably the best measure of inflation at the consumer level that we have, and that's why the Fed has adopted it as their preferred measure of inflation.

I've been worried for almost two years that the Fed's late-2008 quantitative easing would eventually translate into higher inflation, and so far I've been dead wrong. As the chart above demonstrates, inflation—whether you exclude food & energy or not—has been close to or within the Fed's 1-2% target range since early last year. On balance, and since the mid-1990s, the Fed has come pretty close to keeping inflation within target. That's pretty impressive, and that's coming from someone who has severely criticized the Fed in the past.

It's also impressive that core inflation has been relatively subdued and stable for the past two years, because relative price stability is only apparent on an aggregate basis. Some prices have gone down by a lot (e.g., anything associated with housing, plus a lot of durable goods prices), while other prices have gone up by a lot (e.g., most industrial commodity prices). And of course energy prices have gone up and down by an extreme amount in recent years, but oil prices today are just about equal to their average of the past four years.

I hesitate to speak for other economists, but I would have bet money that, prior to the Fed's quantitative easing program which started in the fourth quarter of 2008, virtually all economists would have predicted a significant rise in inflation in a scenario in which—as actually happened—the Fed expanded its balance sheet and the monetary base by well over $1 trillion in a matter of months. I don't have a good explanation for why inflation has not gone up, but on the surface, it would appear that the Fed's massive injection of reserves was just the right amount: enough to keep us from experiencing deflation, but not enough to push inflation higher. From a monetarist point of view, in late 2008 the world suddenly developed a massive demand for dollar liquidity, and the Fed managed to satisfy that demand just about perfectly.

This is not to say that inflation is going to remain well-behaved, however. As Milton Friedman always said, the lags between monetary policy and inflation can be long and variable. It may take years before the Fed's over-supply of bank reserves results in a significant rise in inflation. The U.S. economy is huge and most prices and wages are sticky—there's considerable pricing inertia that must be overcome before prices can rise at a faster clip. But most importantly, the Fed's quantitative easing program has not finished yet; we won't know for some time whether the Fed is able to withdraw its excess supply of bank reserves in time to keep a flood of excess money from washing through the system.

I remain concerned that the risk of a significant rise in inflation is much greater than the risk of deflation. The evidence of an effective oversupply of dollars is already out there: the dollar is very weak, gold prices have soared, and most commodity prices have risen substantially. Plus, there is growing evidence that the demand for dollars is weakening on the margin, as this chart of M2 demand (the inverse of M2 velocity) shows:

One of the unique characteristics of the 2008 recession was the huge and rapid increase in money demand that occurred in the wake of the global financial panic. People the world over suddenly wanted to hold more dollars, and in doing so they sharply cut back on their spending. The dollars that were accumulated in bank accounts (and beneath some mattresses, no doubt) are now slowly being returned to normal circulation. This has the effect of increasing the amount of money available to the economy, which in turn can fuel growth as well as higher inflation.