Wednesday, January 18, 2012

Thoughts on producer inflation

Once again the headline measure of Producer Price Inflation came in below expectations (-0.1% vs. +0.1%), with the result that on a year-over-year basis, this measure of inflation has been declining for the past 5 months. Unfortunately, that good news is fully offset by higher-than-expected core PPI inflation. And unless oil prices spike again, these trends are likely to continue. I note, for example, that the headline PPI is up a cumulative 40% over the past 10 years, while the core PPI is up only 20%; this divergence is bound to narrow over time, with the core measure catching up to the headline measure as higher energy prices slowly filter down to other prices.

One thing that should stand out here is that PPI inflation over the past 10 years (with a compound growth rate of 3.4% per year) has been and continues to be higher than it was in the previous 10 years (when the compound growth rate was 1.2% per year). And what has changed in the past decade? Monetary policy was undeniably tight in the 1990s, but the Fed has been working overtime to be accommodative for most of the past 10 years. That same message can be found in the dollar, which rose throughout the 1990s and early 2000s and has been falling for the past 10 years. It works like this: monetary policy impacts the value of a currency, and a declining currency eventually results in higher inflation.

Another thing that doesn't receive as much attention as it should is that Treasury yields have been lower than the rate of PPI inflation for most of the past four years. We haven't seen such low real interest rates since the highly inflationary 1970s, when the Fed was chronically "behind the curve," repeatedly failing to raise interest rates enough to constrain the high inflation that was triggered by the collapse of the dollar early in the decade.

Low real interest rates, a weak dollar, and an accommodative Fed are a combination that augurs for inflation that continues to surprise on the upside for the foreseeable future. In fact, that's been the case (higher than expected inflation) ever since the end of the last recession. Recall that at the end of 2008 the expected 5-yr, 5-yr forward annual CPI inflation rate embedded in TIPS prices was 0.5%. Instead, the CPI has averaged 2.1% a year over the past 3 years.

When inflation exceeds expectations and real interest rates are uncommonly low for several years running, this has distorting effects on economic activity. Since borrowing costs have been unexpectedly low and the returns to commodity investing have been unexpectedly high, it's not surprising that the mining and related sectors have been on fire, and commodity producers like Australia and Canada are at the top of their game. I wish I knew how much longer this will go on, but one thing is for sure: central banks are setting up the global economy for an inevitable and sharp correction in commodity prices and a return to rising borrowing costs.


Benjamin Cole said...

Well, I suppose I disagree with nearly everything in this post.

If headline PPI (though falling for five straight months) is above the core rate for the last 10 years, we should expect the headline rate to keep falling. Why would core rate rise? I think Scott Grannis has this exactly backwards.

The core rate may or may not pass through to the headline rate---the private sector gets better and leaner every year, using energy ever more efficiently.

But really---headline PPI falls for five straight months, and we are still worried about inflation? At seven in the morning I do not worry about the dark.

I am not sure monetary policy was tight in the 1990s, or accommodative now. Milton Friedman said low interest rates are a sign of tight policy, and we have low rates now.

Many say the Fed is passively tightening, and that is why we see very low interest rates and deflation for five months straight.

The Fed tried to fight global commodities inflation in 2008, through tighter US monetary policy.

The result was a torpedo into the US economy from which we have not yet recovered, but commodities prices quickly recovered. I hope lesson learned. You cannot fight global commodities inflation with US monetary policy. It is like whipping yourself to make a large horse go. You have to let that idea go into retirement.

The right-wing has become deeply encrusted into various hoary economic shibboleths, usually involving a peevish fixation on inflation, and genuflection to gold. It is sad to see, as the right-wing is our pro-business party, and I am pro-business.

George Gilder warned of these off-the-mark obsessions of his conservative brethren, and counseled that growth was the goal, and inflation tolerable, and that commodities inflation was necessary to spur new production (and output!).

I hope the right-wing comes to its senses soon.

Squire said...

I think a policy of dollar and price stability is called for and the destabilizing consequences of that will be self-correcting. In my simplistic view. What do I know.

For instance, I don’t deny that a lower dollar is a benefit to manufacturing exports in the U.S. But a lower dollar is forced in order to bail out our exports. If you don’t use the dollar to bail out the U.S. exports then you will have to use other means, such as trade policy, to deal with the export problem. Perhaps that is preferred instead of monetary authorities running our export policy.

The dual mandate of the Fed (Humprey Hawkins 1978) requires monetary policy to bail out the employment problem. Perhaps instead of monetary policy bailing out the labor problem, policy changes should be made in the areas that inhibit job growth.

Everything seems like a bail out to me.

Benjamin Cole said...

BTW, nice rally on Wall Street today and lately; perhaps investors are figuring out the wisdom of Grannis' commentary.

McKibbinUSA said...

The demands for Federal Reserve Notes in Federal transactions has never been greater -- the result is a shortage of dollars along Main Street USA -- what is needed are alternative currencies that can be used for commerce without tax consequences -- in other words, any transaction completed with other than Federal Reserve Notes would be non-taxable transactions, both in terms of income and capital gains -- tax reform would then focus on regulating the use and flow of Federal Reserve Notes exclusively -- only earnings and business events transacted in Federal Reserve notes would be reportable and taxable -- business conducted with alternative currencies would be considered blind transactions by the Federal government -- this economics stuff is easy once you put your mind to it...

PS: The above scenario is already happening -- watch carefully to see where and how -- in fact, the use of alternative currencies is becoming rampant right before our eyes...

William said...

Scott Grannis wrote: "central banks are setting up the global economy for an inevitable and sharp correction in commodity prices."

Most of the time I can follow your reasoning easily and usually I completely agree. Are you thinking that because interest rate will inevitably rise that commodity prices will then fall?

That maybe true in the long run but the 1970s were an example were, because inflation was rising, commodity prices continued to rise for several years even as the FED raised interest rates - behind the inflation curve of course.

The most important point would be when do you see this "sharp correction" happening. This year or 3 -5 years from now.

Scott Grannis said...

William: As I said, I wish I knew when the reversal in commodity prices will come. Easy money is fueling higher prices, and at some point this will have to reverse and interest rates will have to rise, and that will provoke a commodity price correction. But the timing is very difficult to pin down at this point.