Wednesday, October 15, 2008

Inflation reminder

Producer price inflation is alive and well, even though the index fell 0.4% in September, dragged down by falling energy prices. Core (ex food and energy) prices rose by 0.4% last month, and they are up 4% in the past year. This tells us that monetary policy has been accommodative for quite a few years, because higher energy prices are effectively being passed along to other prices. Non-energy prices are up more in the last year than they have been since 1989. If the Fed were tight, then core price inflation would have declined or gone negative, since higher energy prices would have "crowded out" other prices. That's what happened in 2000: headline inflation rose because of rising energy prices, but core price inflation fell.

So if inflation is trending up, as this chart suggests, why are bond yields so low? In particular, why is the implied inflation rate in TIPS of 10 years maturity or less as low as it's ever been (zero for 5-year TIPS, 1% for 10-year TIPS)? I have long argued that the bond market is not a good forecaster of inflation. Indeed, I think inflation happens when the bond market is not concerned about inflation. Bond yields consistently lagged rising inflation during the 1970s, and they consistently lagged falling inflation in the 1990s and early 2000s. Now they are once again falling behind as inflation rises.

The better forecasters of inflation are gold, the value of the dollar, and the level of real interest rates, and they all say we're in a rising inflation environment because of an excess of dollars relative to the demand for dollars. In the past 5 years gold has soared from $400 to $850/oz., the dollar has fallen against every major currency, and real interest rates have fallen to low and negative levels such as we saw during the inflationary 1970s.


Tory Conservative said...


I keep reading at various economics blogs that it's wrong to give the Federal Reserve a "monopoly" over the money supply.

What does that mean? Is there a way that the money supply can be "set" by the free market? Is this what is meant by "free banking?"

Scott Grannis said...

This raises several issues. For one, the Fed is run by humans, and they can make mistakes by creating too much or too little money. A gold standard would be best, but the political will to do that doesn't exists. Many have argued for years that the next best solution would be to have a free market in money. Let anyone create money, and the one who creates the best (e.g., the most stable) will naturally win. Already we see some hints of this with private sector payment systems like PayPal.

In any event, creating a new money would be similar to what almost every country does: simply create a currency and offer it to the public. A well designed and managed money would soon crowd out all the inferior moneys.