Wednesday, May 13, 2009

Budget update -- awful (2)

A clarification to my post on this subject yesterday:

My comment about the "sometimes-circular logic" of the bond market was not an endorsement of the way the bond market thinks. In earlier posts I've made it clear that I think the bond market is underestimating the risk of higher inflation. One reason for that is that both the bond market and the Fed believe that inflation is largely a function of the strength or weakness of the economy. Call it the Phillips Curve theory of inflation.

As a supply-sider and as a monetarist, I believe that inflation is a monetary phenomenon. I think low inflation is conducive to stronger growth, whereas the Phillips Curvers believe that stronger growth is conducive to higher inflation.

The belief in the argument that growth causes inflation is based on the observation that inflation tends to decline in the wake of a recession. Correlation is not causation, however. Every one of the post-war recessions that we've had have been the result of a significant tightening of monetary policy. (See my posts on the real Fed funds rate and the slope of the yield curve.) So the real cause of declining inflation has always been tight money, not weak growth.

I've been pointing out for months now that despite the economy having hit a major air pocket, there has been no noticeable decline in core inflation. This contradicts the expectations of the Phillips Curvers, and supports the logic of the monetarists. Furthermore, collapsing energy prices have been the major factor depressing inflation to date, and now energy prices are rising again.

As for taxes, the market is correct to assume that higher taxes to fund Obama's expansion of government will tend to weaken the economy. But that doesn't mean that inflation is going to be low forever, as the bond market currently assumes. The inflation threat is independent of the course of taxes. Of course, it's possible that the Fed could try to soften the blow of higher taxes by keeping monetary policy accommodative, but that would only increase the eventual inflation problem.

Finally, I've mentioned before that I don't think higher Treasury yields are necessarily a threat to the economy. Higher Treasury yields will be a good sign that the economy is improving. The economy has thrived for years during periods of rising interest rates. Treasury yields are so low now that they could rise hugely before they posed a threat to the economy. We would need to see a monumental increase in the real Fed funds rate (which is currently negative) and a major flattening of the yield curve (which is now very positively-sloped) before higher interest rates would pose a threat to growth.


Mark A. Sadowski said...

"I've been pointing out for months now that despite the economy having hit a major air pocket, there has been no noticeable decline in core inflation. This contradicts the expectations of the Phillips Curvers, and supports the logic of the monetarists.

This is only true if you fail to look at the data. Core PCE was only 0.6% higher on average in the first quarter of 2009 than in the third quarter of 2008, or up at an annual rate of 1.2%. Until the "air pocket" core PCE was routinely rising on an annual basis in the 2.2-2.5% range. To find a six month change in core PCE that low you have to go all the way back to 1965 (when I was a one year old).

Monetary aggregates have an exceedingly poor record in forecasting inflation owing to the volatility of money velocity. They are notably worse as inflation gets very low (as it has now). That's because the interest elasticity of demand for money approaches infinity as people stuff their mattresses with it. Please don't hold you breath waiting for the hyperinflation to come.

Paul said...


Assuming Obama's planned massive government, debt, and tax tidal wave succeeds, and combined with the SS and Medicare time you foresee economic armageddon or can we somehow shrug it off?

Scott Grannis said...

Mark: Core PCE rose at a 2.3% pace in the three months ended March '09. That is actually a bit faster than the year over year, 2-year, and 5-year annualized pace of prior gains. Core inflation is alive and well. I rest my case.

Scott Grannis said...

Paul: I think we can avoid the doomsday scenario. This economy is very resilient and dynamic. The result of all the spending and higher taxes will likely be sub-par growth for a long time, but growth nevertheless. Unemployment rates will be higher than usual; real incomes won't rise as fast as they have in the past. The best thing that could happen is a popular uprising against all this government meddling. If we could actually turn back the tide of spending that would be incredibly positive.

Mark A. Sadowski said...

I'm consistent in the manner that I measure inflation. The record still stands. Average PCE in the first quarter of 2009 was 0.6% above the average of the third quarter of 2008. That is the least increase in core prices between any two quarters since 1965, period. I know that you know that monthly inflation figures are highly variable so why should we pay too mch attention to them (I'd love to see what you have to say after a few more months).

Scott Grannis said...

Mark: using the average of every quarter introduces a lag into your results. I prefer to use monthly data and compensate by allowing for natural variability. But it seems to me that, especially in the first three months of this year, the economy was so far below trend that it should have had a discernible negative impact on core inflation. But it didn't. I will be happy to admit I'm wrong if things turn against me in the future. Seems like one us is sure to be wrong.