Wednesday, August 3, 2011

Thoughts on inflation and growth

This chart shows the 6-mo. annualized rate of change for the headline and core versions of the Personal Consumption Expenditures Deflator, the Fed's preferred measure of inflation. Both measures of inflation now equal or exceed the Fed's professed inflation target of 1-2% on the core measure of inflation. Note also that both measures exceeded the Fed's target most of the time from 2004 through 2008. That period, of course, was one in which the Fed pursued very accommodative monetary policy because the economy was perceived to be relatively weak and deflation was thought to be a threat.

As I mentioned last week, the GDP revisions that resulted in lower growth and higher inflation must have come as quite a surprise to the Fed, especially since the Fed holds to the theory that very weak growth (and growth well below potential) should result in lower, not higher inflation. Now, not only has inflation turned up when it should have turned down, but the Fed's understanding of what makes inflation tick has been called into question once again.

This is not to say that we have an alarming amount of inflation on our hands, because we don't, at least according to the official inflation statistics. The important thing here is that the Fed's theory of inflation (aka the Phillips Curve theory of inflation) has not done a good job of predicting or controlling inflation. Meanwhile, the classical theory of inflation—that it is fundamentally a monetary phenomenon and has nothing to do with how strong or weak the economy is or whether there is a lot of resource slack or not—has done a much better job. There has been abundant evidence for some time now that the Fed was being too accommodative by supplying more dollars to the world than the world wanted. The evidence has been in plain sight, and supplied by market-based indicators: the very weak dollar, the rising prices of gold and commodities, the very steep yield curve, and the rise in inflation expectations as embedded in TIPS prices.

The classical view of inflation says that as long as the evidence points to a surplus of dollars in the world, then inflation will tend to move higher. So once again I conclude that investors should pay more attention to the risks of higher inflation rather than to the risks of deflation. That translates into a preference for asset classes with exposure to rising prices, such as equities, real estate, and commodities. At the same time, it argues for extreme caution in regards to Treasuries, especially since they are trading at very low yields. Treasuries have done very well of late, but that is not a reason to like them, since the lower yields go the more than prices stand to fall in the future if inflation does indeed move higher.

Finally, this analysis also suggests that the Fed is going to find it very difficult to justify another round of quantitative easing. There's too much inflation and too much uncertainty right now about where it's headed (did I mentioned the huge increase in the volatility of inflation in the past decade that is evident in the chart?) for the Fed to risk another massive easing effort. The economy is not at all starved for liquidity; there is plenty of money out there.

What is lacking is the willingness of investors and corporations to risk their money in the pursuit of new and productive ventures. There's not enough confidence in the future, there's too much concern about increased regulatory and tax burdens, and there's too much concern about the future value of the dollar. When those concerns subside, new investment and stronger growth should follow.


Benjamin Cole said...

Good commentary.

Still, I would rather live in boom times with 4 percent inflation, than in Japan.

People act like 4 percent inflation is worse than getting AIDS. Yet we had moderate inflation all through 1980s and 1990s, and we boomed. Even into the 2000s.

Now we have to target 1-2 percent inflation?

Due to wage stickiness, and the need for Dutch courage on the part of small businesses and real estate developers, I think we need moderate rates of inflation, and solid growth. Productive borrowers are more important than bondholders to economic growth--especially now, with gobs of global capital everywhere.

The Japan scenario I do not find appealing. Bernanke-san is taking us there, along with profligate spending of both parties.

Anonymous said...

Inflation is fine if you've got growth first. But getting inflation before you get meaningful growth is not what the doctor ordered.

Mike Eliason said...

Do you think the Fed should stop using the inflation rate as the primary metric for how loose/tight their policy is? Maybe they should rely more exclusively on market based indicators?

For instance, in the last decade, the CPI never really overheated, but clearly loose Fed policy is what fueled the housing bubble. At the same time, I don't think the Fed should be in the business of popping bubbles (that's a part of what led to the Depression), but surely there are better metrics they could base policy on than the inflation rate.

Scott Grannis said...

Mike: you might like "Monetary Policy: A Market Price Approach" by Johnson and Keleher, in which they propose what you suggest.

Stone Glasgow said...

Wouldn't the value of the dollar go up when the amount of trade increases? After all, if people are trading more heavily there would be a higher demand for the medium of exchange, right?

Why can't both theories work together? Inflation is affected both by the level of economic activity, and the supply of dollars.