Friday, January 14, 2011

Even though inflation is low, monetary policy is inflationary

The CPI rose 0.5% in December, somewhat more than expected. Most of the rise was due to a big jump in gasoline prices. Ignoring energy prices, the CPI rose a mere 0.8% last year, and the headline CPI rose only 1.3%; that takes us all the way back to the very low and relatively stable inflation rates last seen in the early 1960s.

These tame statistics don't tell the whole story however. In the past six months, the CPI has increased at a 3.1% annualized rate. More importantly, the CPI ex-food and energy has been rising steadily (albeit at a bit less than 1% per year) for the past several years, even as energy prices have been soaring. If the Fed were pursuing a policy of price stability (which they are not, unfortunately), then a big rise in energy prices would necessarily result in a decline in non-energy prices, thus leaving the overall price level unchanged. But that's not happening. By being accommodative, the Fed is allowing higher energy prices to occur, without forcing other prices to decline. This is a recipe for more inflation.

If nothing else, this fact—that monetary policy is definitely accommodative—all but rules out the risk of deflation. As deflation risk fades into obscurity, markets are waking up to the fact that it's possible to raise prices and get away with it. Thus, nominal growth expectations are rising, inflation expectations are rising, and the combination is driving higher earnings expectations, thus lifting stock prices. Inflation and inflation expectations are still relatively tame, thank goodness, but this we are not in a stable, long-term equilibrium condition. Facts and expectations can change dynamically, but we don't know whether the Fed can adapt with sufficient speed and determination to changing conditions. This is no time to be lulled into a sense of low-inflation security.


Bike said...

Scott - this is off topic - but would appreciate your thoughts/comments/suggestions on the municipal bond market bloodbath currently going on.

Thank you

septizoniom said...

now this is a good post.

Benjamin Cole said...

I sure hope Scott is right, and we have some moderate inflation ahead. Scott has been making a face about inflation longer than Seabiscuits'. And where is the friggin' inflation? You need a microscope to see it, and a telescope to see any coming.

"If the Fed were pursuing a policy of price stability (which they are not, unfortunately), then a big rise in energy prices would necessarily result in a decline in non-energy prices, thus leaving the overall price level unchanged."

Well, this is an interesting passage, but I think the bottom of a recession is the wrong time to pursue price stability (as Japan has repeatedly found out).

Pursuing price stability now could easily lead to a perma-recession. Really? You want real estate and wages to keep going down just because China is buying a lot of oil, and the NYMEX has become a speculator's playground?

I think the biggest danger in the world today to the USA is the Nipponistas--those who call for price stability in a weak economy.

Right now we need to blow the doors open, print money until the plates melt, and cut taxes and regs.

We have done two out of three, and it seems to be working.

Benjamin Cole said...

Another nice rally on the Dow--if this keeps up, my prediction of 13k on the Dow in 2011 will seem rather tame.

One or two more more good weeks and we hit 12k--and I think that will like the gates opening, for many investors.

Of the market smells a bull, money could come out of commodities btw. If gold starts to weaken, it could weaken for a few decades. That has happened before, and in the recent past.

Meanwhile, those who have eschewed stocks have missed a huge rally, and I suspect another sustained rally coming.

My grandfather used to say, "All gold is fool's gold. They don't make any other kind."

Scott Grannis said...

Bike: Re the muni market

The muni bond market is obviously distressed, but the question is whether valuations are accurately reflecting the risk of potential municipal defaults. I do believe that there will be some meaningful muni defaults before all is said and done, but I just don't know if that will be more or less than what the market has priced in already.