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The August rise in consumer prices exceeded expectations. The headline CPI rose 0.4%, vs. an expected 0.2%, while the 0.2% rise in the core rate was a tad higher than expected. As the first chart above shows, core inflation over the past six months is running at an annualized rate of 2.7%, while overall inflation is 3.6%. As the second chart shows, the rise in core inflation has been quite pronounced, and apparently owes a lot of its strength to the Fed's second round of Quantitative Easing which began almost a year ago.
What is most impressive about the rise in core inflation is that it has happened at a time when the economy has been demonstrably weak and the output gap has been gigantic (10-12% by my estimation). The main reason the Fed was so anxious to engage in QE2 was that it feared the output gap posed a serious risk of deflation. The bond market has been willing to ignore signs of rising inflation because of the pervasive belief that a large output gap provides an insurance policy against rising inflation. Yet these beliefs are being challenged almost daily. Thus, the Treasury market is perched very precariously on the edge of acceptable valuations, as real 10-yr Treasury yields are now clearly in negative territory.
Here's a Big Picture thought: what we see happening over the past year or so is the gradual undermining of widely-held theories about how the economy and inflation work. Keynesian economic theory is taking a beating, because it was used to justify a $1 trillion government spending stimulus package that not only failed to stimulate the economy as predicted, but most likely helped to weaken the economy. The Phillips Curve theory of inflation is also taking a beating, because inflation is much stronger than it has been predicting, given that unemployment is still very high.
The bad news for Keynesians and Phillips Curvers, however, is good news for supply-siders like me. Supply-side theory has been predicting relatively slow growth and a tepid recovery for over two years, since it recognizes that deficit-financed spending has no power to generate growth, and big increases in the deficit inhibit risk-taking because they tell the market to expect big increases in tax burdens in the future. (Two consistent themes of my predictions since early 2009 have been that the economy was likely to grow, but at a sub-par pace, and that inflation was likely to rise.) Rising tax burdens reduce the after-tax rewards to work and investment, so you end up getting less of both.
Monetarists and supply-siders have been predicting rising inflation for over two years, since they recognize that accommodative monetary policy, when fortified by a very weak currency, rising gold and commodity prices, a steep yield curve and low to negative real yields, will inevitably lead to higher inflation regardless of how weak the economy is. Indeed, in the supply-side framework, a weak economy is to be expected when monetary policy is inflationary. That's because easy money weakens a currency, and that increases the rewards to speculative activity while reducing the rewards to investment, and with weakened investment you get weak growth.
Along with the decline of Keynesian theories and the rise of supply-side theories, we are seeing a powerful realignment of political power in Washington. Obama, a dyed-in-the-wool Keynesian, is still insisting that what we need is more spending and more government control over the economy. But he is fighting a losing battle as more and more people begin to realize that Big Government is antithetical to prosperity. Keynesianism is all about giving power to politicians so they can pull the levers that supposedly will create growth, but now we see that politicians are fallible just like anyone and spending other people's money is never a very productive enterprise. Indeed, giving a handful of individuals who happen to inhabit Congress the power to spend a trillion dollars they don't have is so foolish as to be dangerous to our economic health.
What we can expect to see more of, fortunately, is policies that return power to the private sector, while also increasing the after-tax rewards to work and investment. Even if it takes a year or so for policies to make a clear shift in a more pro-growth direction, the prospect of improvement and the fact that in the meantime the economy is likely to continue to grow, should be enough to push equity valuations and Treasury yields higher.
17 comments:
An excellent post, but I think just misses the correct conclusion.
Yes, deficit spending may not help, and obviously, the less government impediments, the better.
But we fit closely the Japan scenario. But that I mean that just bringing interest rates down to zero (the market may do that anyway) is not effective--we need a sustained nominal GDP target that the Fed publicly shoots for.
So, the right policy is less government total tax bite, less regulation (although this is very often a state and local issue) and an aggressive, confident Fed policy of QE and limited interest on reserves. The Fed will encourage some inflation in this manner, and that will be healthy for real estate markets, banks, and to help the economy deleverage.
Inflation is also a side issue, and I am baffled by the current obsession with inflation rates that are below rates that Reagan/Volcker obtained when they were thought to be victorious in the fight against inflation.
Firstly, rates are very low, despite some recent readings--the CPI is barely up from three years ago.
Commodities prices are set on global markets, and often the USA economy is a smaller player than China, India and Japan, or speculators on exchanges.
Gold is on the moon, and I would not draw any conclusions from the yellow metal. The only conclusion I draw is that I wrong not to buy gold.
Besides, as Milton Friedman would tell you, fighting a recession with tight money is the way you get a depression.
Money is tight now. Low interest rates are not a sign of easy money, but rather a sign that money has been and is tight, as Friedman stated.
Indeed, when Friedman advised Japan in a very similar situation in 1997, he told them to print money until economic growth surged and they got inflation. I like that idea.
"Indeed, giving a handful of individuals who happen to inhabit Congress the power to spend a trillion dollars they don't have is so foolish as to be dangerous to our economic health."
Perhaps, but that power is firmly established in the Constitution. To say they don't have the $trillion is misleading given that the U.S. Treasury has its own currency and can print the money.
Scott -
Won't operation twist/torque work to bring long term yields down, not up?
While the US is still involved in a horrific economic situation (especially along Main Street), the US Federal Reserve is busy pouring dollars into European banks -- more at:
http://on.wsj.com/nV9AFG
The situation must be very serious in Europe -- I'm surprised that the Fed has found money available to provide to European banks...
Although your analysis is interesting I just don't buy the premise. The reason that Keynesian solution have not worked is that for all the Fed's printing little has ended up in loans, mostly it sits on bank balance sheets -- unlent! Velocity of money is way down.
The cycle we are in is not a manufacturing recession but a balance sheet recession.
Granted that the Keynesian tools don't work, but nor will the monetarists! An economy that relies on consumption for 70% of GDP growth is screwed when the consumer decided (willingly or otherwise) to reduce debt.
This is a 10 year cycle. Moreover, America is a service economy, but how can a service economy with 9% U2 and 16% U6 unemployment (and the lowest labor participation rate in a decade) have inflation?
Sure oil prices (but again must consider flow and not price points) or commodity prices will create some inflation, but in what universe can you have inflation in a debt reducing environment.
42% of the stimulus consisted of tax cuts. Is that Keynesian or Austrian economics?
So Inflation has picked up from almost the lowest rate in 70 years or so.
We have over 9% unemployment (16% plus of U6) and large capacity underutilization.
This does not sound like prices will be out of control any time soon.
I think that their is something to be said about the minimal new investment in oil drilling, mining and even agriculture during the late 1980s and the entire 1990s because the prices of these resources were so low. Until the finding of a large oil reserve off the coast of Brazil 10,000 feet deep and beneath rock salt, there had not be a huge discovery in 30 years. Likewise for mining, the large loads of copper and other minerals in the world are known and nothing vast has been found in decades. What oil and minerals reserves there are to obtain are increasingly costly to extract.
Secondly, when it comes to natural resource use, one can't simply look at the USA. Many countries around the world are developing middle classes - thanks unwittingly to US consumers' demand for their goods. So while natural resources are increasingly more expensive to extract and somewhat scarce, the global demand - not just from the USA - is increasing.
The price increases in hard and soft commodities do work their way through the global economy -including the US economy. But the "inflation" which is turning up in the US CPI is due to the above factors which to a large extent are external to the slow US economy.
I'm not certain that "inflation" is the correct term - it is more the relative scarcity of these resources which is causing the price increases.
Not being an economist my words are not precise. But I believe the explanation of the phenomena being discussed lies in the global economy - not in one economic theory versus another..
Re: operation twist. If it happens, which I doubt, it would only be successful if long-term yields rise. Rising long-term yields would be the only outcome of a fundamental pickup in the strength of the economy and/or an increase in inflation.
Re: tax cuts. Yes, a large part of the Obama stimulus consisted of tax cuts. But they were only temporary and targeted tax cuts, and those don't change people's behavior, nor do they change incentives for the entire economy. The only tax cuts that would be beneficial would be those that are permanent, such as a permanent reduction in the corporate tax rate, or a permanent lowering and flattening of income tax rates.
Cutting payroll taxes is simply akin to spending money. It doesn't work.
Quick question. Would CPI levels be dramatically different if home prices instead of rents were still included in the calculation?
"The only tax cuts that would be beneficial would be those that are permanent..."
We agree, then. The Bush Tax cuts of 2001 and 2003, scheduled to expire in 2010 and extended for another 2 years have not been beneficial to the economy. Better to let them expire and remove the uncertainty.
Regarding the flat tax: Michigan has a flat income tax. It doesn't work very well and I expect Governor Snyder, a Republican, will try to change it to a graduated tax.
Great analysis as usual Scott!
"As a tool for advancing the interests of the political class, then, inflation under fiat money and a central banking is distinctly polytropic; it is capable of rendering a hidden tax that centers the entire economy on a small cartel of strategically positioned bankers, who have no interest but to sponsor — again, with worthless fiat currency — the expansion of government control over our lives. Coincident with the centralization of power within the bowels of the state, business decisions too are increasingly concentrated, enmeshed in the modern-day nobility of the banking sector.
And the reason is simple enough: insofar as saving is at every turn discouraged by the monetary system, businesses become more and more reliant on debt, financing their endeavors with credit flowing from a naturally meddlesome class of lenders. Tethered to the condensed power of the big Wall Street banks, the economy becomes rigid and sclerotic, precluding the nimbleness and innovation that would reign in a genuine free market. Fiat inflation, Hülsmann argues, "creates greater hierarchy and central decision-making power than would exist on the free market."
http://mises.org/daily/5562/The-Real-Solution-to-the-Debt-Problem
Re: CPI if home prices instead of rents were used: I seriously doubt this would make a dramatic difference, but that switch, which occurred in the early 1980s, did have an impact on CPI, which is one good reason why CPI is not the best inflation measure to use. Much better to look at the PCE and GDP deflators, since they are much broader and much less influenced by home price or rents. Since the end of 1979, total inflation according to the CPI has been 194%, and according to the GDP deflator it has been 151%. Thus the level of the CPI today is about 17% higher than the GDP deflator, and the CPI has increased on average about 0.7% more per year than the deflator. That might be a first stab at an answer to your question.
Your mortgage payment on a median-priced house today in CA is $982 vs. $2,237….in 1987.
Inflation?
Or deflation?
I contend we are in the latter...and bond markets show it. These yields only make sense if you assume the CPI overstates inflation by quite a bit, maybe 1.5 to 2 percent a year.
Ben,
What you are describing is contraction neither deflation nor inflation.
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