Monday, August 30, 2010

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.


Benjamin Cole said...

Excellent commentary.
As for me, I say bring on the inflation.
Japan has had no inflation for 20 years, just about. Price stability may be death on the "animal spirits."
People and lenders feel better if they know that inflation will bail them out ultimately, even if the lend or borrow and things go sideways.

And right now, we badly, badly need reflation in property values.

I have been saying the Fed ought to print money until the plates melt, and even that may not be enough.

I would rather live through a inflationary boom, than a long deflationary recession, or even a stable-price recession.

Right now, our economy is starved for money.

If you are an excellent counterfeiter out there, this is your hour. Print up lots of mula, and spend it. Supposedly, Saddam Hussien once printed ersatz U.S. money so fine in quality it could not be detected.

The Fed has a fetish for price stability, but I would rather get the economic engines going again.

Jason and Jen said...


I am sorry to interject as often as I have lately. If the cash printed by the Fed just landed back on reserve with the Fed, why would you think it would result in inflationary pressures? Yes, cash washes throught the system, but its effect is only temporary as it has simply landed idle on reserve. Perhaps I am severely underestimating the possibility of a sudden and uncontrolled demand for credit via the banking system. Although, I doubt it at this point. Have you been surprised by the lack of credit demand?

Benjamin Cole said...

BTW, read today in the WSJ that China makes 45 percent of the world's glass. The USA about 10 percent.
In terms of commodity demand, China dwarfs the USA in many, probably most markets.
In a sense their real economy is larger than ours--real goods, and construction.
Our economy counts a lot of guys sitting in their chairs in law offices, accounting firms, etc. The whole financial services industry in the USA produces nothing, but consumes the lion's share.
Using global commodity prices to gauge US inflationary pressures seems less and less likely to produce a useful result.
Egads--inflation is trending under 1 percent, has been trending roughly down since the early 1980s, and yet Grannis contends i"it is still a concern."

I would like to know just what conditions have to apply before we can stop being concerned about inflation.

Charles said...

Fed policy at the aggregate level is about right. Perhaps a little tight. The fed is paying an above market interest rate on excess reserves. As a result demand for certain kinds of money has soared.

We need to remember that macroeconomics is all about abstract constructs that can be impossible to measure accurately and that are difficult to estimate in a consistent way. Money, price level, real GDP are all examples of this.

When the government takes extreme policy actions and when huge structural adjustments in the economy are underway, the situation gets muddy real fast.

We know that a huge amount of paper wealth has evaporated. We know that millions of jobs based on phony wealth are gone forever. We know the federal budget is on an unsustainable trajectory. We know that consumption must fall and be replaced by investment. And it is reasonable to conclude that the administration's policies are destroying business confidence and obstructing the necessary adjustments.

Rick said...

Isn't the PCE deflator at the upper end of the Fed's acceptable range? In reviewing the last BEA report, if not for the decline in the price of imported oil, would not the deflator have been higher than 2.0?

Scott Grannis said...

Re: "what conditions have to apply before we can stop being concerned about inflation?"

I would argue that we would need to see a) a significant decline in gold and commodity prices, b) a significant rise in real yields, c) a significant flattening of the yield curve, d) a significant rise in the value of the dollar, and e) a significant rise in money demand.

Scott Grannis said...

J&J: I doubt there would be a sudden decline in the demand for money. I think instead we would see a gradual decline in the demand for money, and a Fed response to that proves to be too little, too late, much as we saw happen in the 1970s. So the real threat is that credit demand would rise slowly (which is another way of saying that money demand would decline slowly) and the Fed would not react in a timely fashion--leaving interest rates too low and too many reserves in the banking system.

Benjamin Cole said...

Gee, and I thought we should worry about inflation when we have inflation. By your standards, we worry about inflation whether or not we have any--a lot like the BoJ worries.
Maybe it's just me, but when the economy is slow and inflation is below one percent and sinking, and when interest rates are negligible--I would say we need a huge shot in the arm.

We seem to agree that a fiscal shot is not a good idea. That leave monetary, and structural reforms.

I am all for structural reforms, but does anyone realy think we can eliminate the rural welfare economy, shrink the military, wipe out the mortgage interest tax deduction, zap the minimum wage, and wipe out Fannie and Freddie?

All good ideas, and all not going to happen.

So bring on the Fed, big-time.