Forget about deflation risk

Producer price inflation in April was quite a bit higher than expected (+0.6% vs. +0.2%), and core (ex-food and energy) prices jumped 0.5%. April consumer price inflation, on the other hand, was about as expected. However, both the total and core versions of the PPI and the CPI now say that inflation in the past year has been at least 2%, whereas they were registering levels of less than 1% about six months ago, as shown in the following charts.

Could this be the beginning of a significant increase in inflation? Perhaps, but it's still premature to make that call, even though I've been worrying about rising inflation for the past five years. What it does say, however, is that deflation is a no-show. This is not the stuff of which deflations are made.

Fed monetary policy for years has been geared to fight the threat of deflation, and policy is still dominated by the fear of inflation being too low. Adding to the Fed's concerns were the still-sluggish rate of economic growth and the unprecedented "output gap" (i.e., idle capacity, which I estimate could be at least 10%) that is still growing despite 5 years of unprecedented monetary and fiscal stimulus. Conventional economic thinking would have thought this impossible, and conventional thinking today worries that the weak economy will surely exacerbate the threat of deflation, because we supposedly have too many goods and services (i.e., too much supply) chasing too few dollars (i.e., not enough demand).

Yet now we have inflation at 2% or more, at the top of the Fed's preferred 1-2% range, at a time when the Fed still has its metaphorical pedal to the metal. I have argued for years that the Fed hasn't really been printing money, so I don't think this metaphor is apt, but I've also noted that the justification for the Fed's massive bond purchases (the world's extraordinary demand for money and money equivalents) likely won't last forever. The recent pickup in inflation is one more sign that the demand for money may be easing, and if so, then the Fed's extraordinary supply of money may create an oversupply of money. If inflation starts to register 3% or more, (I'll take a bit of deflation any day rather than inflation of more than 2% a year) then that will have huge implications for monetary policy. The Fed is going to have to accelerate its tapering and shift into tightening mode, and interest rates are going to move higher across the board, by much more than the market currently expects. I'm not sounding the alarm yet, but it's a risk that can't be ignored, no matter how weak the economy's growth rate.

Weak economic growth does not inoculate an economy against inflation. On the contrary, inflation often thrives when growth is weak, and too much inflation can seriously debilitate an economy. I should know, since I lived in Argentina for four years in the late 1970s, during which time economic growth was abysmal and inflation lived in triple-digit territory. If the Fed responds to the threat of higher inflation in a timely and adequate fashion, there is no reason that should hurt the economy.

This business cycle has been a boon to economists, because it has destroyed the progressive myths that government spending and easy money can stimulate an economy. It has also destroyed the Phillips Curve theory that says that persistently high unemployment leads to low or negative inflation.

So now we await the dawning of a new era of public policy, one which I hope will be dominated by the belief that monetary policy and fiscal policy need to focus on delivering conditions that are optimal for the private sector to thrive: low marginal taxes, low and stable inflation, and low regulatory burdens. Washington needs to reduce marginal tax rates on businesses and individuals, while also eliminating deductions and subsidies. This shouldn't be too difficult, given the dramatic progress to date in reducing the budget deficit. Reducing regulatory burdens is also critical, since they impose a deadweight loss on the economy. It should soon become obvious to everyone that Obamacare is only making things worse, and that only by introducing market-based reforms can we improve healthcare.

Deflation is not a threat; Big Government is.