A Competing View of Inflation

Professor James Hamilton has offerred an interesting view of inflation (recent Consumer Price Index data) on his Econbrowser weblog that run somewhat counter to ours:

…does it make any sense to ask, What if energy prices hadn’t gone up between May and July? There are certainly good reasons why the Fed should not be taking as much comfort in "core inflation" as it has in recent years. But in this case, there is a clear need to net out the May-to-July energy price increase– it’s already been reversed. The US national average gas price is back to $3.78/gallon, right where it was in mid-May. Thus, even without any further drop in the price of gasoline– and personally, I do expect further drops– the 4-1/2% number is a better summary of where we stand right at the moment than 5-1/2%. So no, I don’t think that yesterday’s CPI numbers will cause the Fed to panic. Because yesterday’s news is already way of out of date.

Of course it’s true that a piece of data that comes close to its expected level doesn’t matter a whole lot. What counts, especially for inflation, are longer term expectations. But we still view the most recent PPI release as a data point that mattered, because it surprised significantly to the upside; and if that continues, it could eventually undermine existing inflation expectations. Thus, whether the Fed ought to panic about inflation is still unsettled. And while we’re on board with the idea that if the rest of the world slows down in train, the Fed won’t need to panic, we think it’s the developing, not the developed economies, that are going to make the difference in the end. For example, Menzie Chinn (Hamilton’s co-blogger) linked this report from the Dallas Fed on slowing global growth, which notes the following:

The expectation that the global slowdown will bring inflation under control has yet to materialize. Several developments have contributed to the buildup of inflationary pressures. Among them:

- The prevalence of an implicit dollar-zone in parts of Asia and among commodity exporters may contribute to rising global inflation. Maintaining the zone has required monetary policy accommodation in the face of a commodity price shock and a weakening of the dollar.
- Wage indexation schemes around the world, even among countries with a free-floating exchange rate (the euro zone, for example), may contribute to second-round effects on wages from the commodity shocks and to rising labor costs.
- Signs suggest that the secular trend of decline in transportation costs may have stopped over the past years. The recent collapse of the Doha trade negotiations is also a missed opportunity to boost trade and reduce trade costs through lower tariffs.

The Dallas Fed report also contains the following image, which is a great visual tool for understanding the sources and impacts of rising prices:

If the second dynamic in the Dallas Fed report (the risk that wage indexing in many parts of the world heads higher) comes to pass, then all bets are off–inflation expectations will come increasingly unhinged worldwide, and the dreaded wage spiral will also unfold in the U.S., in one form or another (as described in our August 19th post). That may not be a high probability event yet, and the ECB is doing all it can to prevent it. But it’s still our view that: (1) the ECB can’t prevent global inflation without the Fed pulling in the same direction; and (2) it will take more than a slowdown in the developed economies of the world to dampen global inflation pressures significantly. To assume otherwise on that last point is to repeat one of the most important errors made during the stagflationary 1970s. Whether we experience more or less inflation in coming years will depend heavily upon the relationship between the Federal Reserve’s monetary stance and the economic policies and performances of developing markets. At the moment, the outlook for those economies still looks pretty healthy, while the Fed does not yet appear to be in an inflation fighting mood*.

* To the Fed’s credit, it has administered its Term Auction Facility (TAF) in a way that prevents it from acting as a source of additional USD inflation. The open question is whether a 2% fed funds rate target is still far below neutral (i.e., non-inflationary).

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Another interesting item on Econbrowser Hamilton’s U.S. recession probability model that he co-developed with Marcelle Chauvet. At the moment, it’s giving a reading of 38.4%, as noted in the right frame of the Econbrowser homepage. Hamilton and Chauvet’s rule of thumb is to call a recession only when the index reaches 66% or higher. However, if you look at the historic readings, you’ll note that for the entire period covered, every time the index has reached this level, a recession followed shortly after. Sticking with our mantra: not good. Not as bad as the 1970s, but still not good.

The Inflation Genie – Still out of the Bottle

Today’s Producer Price Index data show emphatically that the inflation genie has yet to be stuffed back into its lamp. The monthly change in finished goods prices for July was 1.2%, which was twice the consensus estimate of economists, and it increased 9.8% year-over-year from June 2007, keeping a steady uptrend intact.

Also worrisome is that crude and intermediate goods prices still show upward pressure, which implies higher prices in the pipeline. In August, our indicators did begin to signal that inflationary pressures will moderate a bit, so we expect the PPI to soften some in coming months. However, an important caveat is that they are still relatively high, and inflationary pressures have not yet fed through fully into the overall level of prices.

It continues to be our view that inflation, income, and asset price trends are echoing the 1970s, and on that point, we find ourselves in agreement with Merrill Lynch economist David Rosenberg* who recently remarked:

We’re heading into…the onset of the first consumer recession since 1990-91. I would argue that this could end up being very similar to that six-quarter consumer recession that we endured from 1973-75. There are differences, but there are similarities. A lot of people like to compare this to [1990-91], because of the real estate flavor and credit crunch, but there is actually a lot more going on that compares it to 1975…

What is the cash flow drain on the household sector from [credit contraction, asset deflation, and higher unemployment] in the coming year? The answer is $800 billion…That is a huge number. It’s equivalent to 12% of discretionary spending, which, by the way, is exactly the peak-to-trough decline in real consumer cyclical spending back in the 1973 to 1975 recession.

Clearly, U.S. households are in for a long period of balance sheet repair. Unfortunately, it’s going to unfold against a backdrop of likely government policy directions–in the form of rising taxes, mandates, entitlements, regulations, and trade barriers– that will make the process more difficult and time consuming. This will in turn pressure the Fed to address the resulting economic damage with easy monetary policy, which will keep a match under global inflation.

Meanwhile, many U.S. policymakers and economists have been reassuring themselves that, unlike the 1970s, there isn’t going to be a "wage spiral" in the U.S. that will cause inflation expectations to become unhinged, to which we would point out the obvious: any imminent or ongoing wage spiral is going to happen (or is already happening) overseas; it’s going to be exacerbated to the extent that major central banks use monetary easing to combat domestic slowdowns; and it will shake up inflation expectations eventually (indeed, it already has in many parts of the world). As Morgan Stanley strategist David Darst pointed out recently, "the inflation rate for 42% of the world’s 6.5 billion people is over 10%." How wage spirals will play out in disparate institutional frameworks acoss different countries and regions remains to be seen (in the U.S., it was largely accomplished through union activities). We don’t expect the process to be simple or uneventful.

What sort of adjustments might occur in the U.S., assuming we don’t see rising wages? One clear possibility is a longstanding consumer recession of the kind described by Bernstein. Less obvious, but based on clear demographic realities, is the likelihood of a "benefits spiral" in the U.S., be it in Social Security, pensions, Medicare, health benefits, or elsewhere. We could eventually see taxpayer  and/or shareholder revolts, and even more stubborn retrenchment in consumption among pre-retirees.

Many of these problems could be ameliorated with the right policy mix–lower taxes, regulations, and tariffs, in concert with a stronger monetary stance from the Fed. Unfortunately, this outcome seems highly improbable in the near future, leaving us to repeat our current mantra: Not good…

* The comments from David Rosenberg posted at the Investors Insight web page are transcribed from a recent conference call–if you read it, be aware that there appear to be some transcription errors that could cause confusion.

Trichet’s Smackdown?

Watching commodity prices fall off a cliff today inspired us to gather some evidence for our offhand observation that the rolling over began in July, when the ECB raised rates to combat inflationary pressures (an issue we briefly commented on yesterday). This assertion is based on timing, and is supported by the intellectual and institutional foundations of the ECB, which are clearly of a neoclassical and monetarist bent, as embodied in its mandate to focus solely on price stability.

Graphically, it does look like the ECB’s actions played a decisive role, as gold began to fall rapidly after the ECB rate announcement (down over 10% since July). However, the Euro/USD exchange rate has moved in favor of the dollar, an unusual development when gold is falling.

So did Trichet smack down both commodities and the Euro last month? Hard to say. It’s well established that both commodity prices and foreign exchange ratestent to "overshoot" in response to monetary shocks, and after a huge run up, gold did appear to be trending down before the ECB’s July rate hike. However, the importance of the ECB’s direction shouldn’t be understated. Fact is, there are now two central banks setting monetary policy for the world, and to have them moving in opposite directions means that the marginal cost of money is going to lie somewhere between their target rates. By hiking while the Fed stood still, Trichet raised that marginal cost, which should have a negative impact on commodity prices. But it could also have a very negative impact on the eurozone economy. 

In fact, we suspect that much of the current market turmoil is due to uncertainty about future policy direction from the ECB. As an institution, it is designed to be far more resistant to political pressure than the Federal Reserve is. Will it be able to maintain this, given the pessimistic expectations developing in Europe? Time will tell. If so, we’d expect the USD rally to be relatively short lived, and for commodity prices to stabilize. If not, we’d expect exchange rates to become especially volatile, and for global inflation pressures to rebuild.  

Dismal inflation and real earnings numbers

Bureau of Labor Statistics (BLS) data on consumer price inflation and real earnings printed some dismal numbers today. CPI was up 5.6% year-on-year, a 17 year high. The month-over-month change came in at 0.8% versus expectations of 0.4%, and the core rate came in higher than expected at 0.3% versus 0.2%. A core rate around 3.6% is not something to cheer about, especially given its continued upward trajectory.

Real average weekly earnings provided further evidence for our ongoing stagflation thesis. While average hourly earnings rose 0.3% month-over-month, average hours worked fell by the same amount. Thus, the entire CPI reading ate into real hourly earnings–that’s not good for wage earners, nor is it good for future economic performance.

There is widespread hope that  the recent pullback in commodity prices will pull down the hot headline inflation rate. That should prove true in the short term, but feed through effects are still in the pipeline. We also think that commodity prices are going to stay stubbornly high despite their recent pullback. Why? Because policymakers in the U.S. have fallen into the same flawed thinking that got them into trouble in the 1960s and 70s, i.e., that monetary policy and tax/fiscal/trade/regulatory policies are interchangeable. In other words, if tax or regulatory burdens increase (thereby lowering the expected rate of growth in the economy), monetary policy can be used to pick up the slack without causing inflation. If the U.S. were a closed economy, that would be true. But there’s a global economy out there that is financed heavily by U.S. dollars, and that is still growing at a relatively healthy clip. That means that the Fed’s target rate is still too low.

Of course, we’re not blind to the pain that a ‘neutral’ (non-inflationary) fed funds rate would cause. Domestic money supply and credit would contract further, and domestic unemployment would increase at a faster rate. The only way to dampen the negative domestic effects of a sounder monetary policy is with well designed, pro-growth policies at the federal, state, and local levels. Policymakers learned this lesson in the late 1970s and early 1980s, and it was embraced by JFK in the early 1960s. Apparently it needs to be learned again.

However, government policies currently appear to be headed in the opposite direction. Taxes in the U.S. are almost certain to rise in 2009 and beyond. We may see a cut in the corporate tax rate, which is good, but at 25-30% it would merely help us catch up to the rest of the world (ex-Japan). And it will be neutral at best if the overall tax burden increases as much as expected and if trade and regulatory barriers are raised. Government spending is likely to rise too in the coming years in the name of "stimulus".

Higher taxes and massive public spending are key characteristics of Japan’s economic stagnation since 1989. In fact, things got so bad that the Bank of Japan ran into a "zero bound" problem–it could not lower its interest rate target below zero, even though trend growth was negative (there are ways around this, such as the "quantitative easing" measures the BoJ took a few years back, but those are highly unusual and somewhat risky measures for central bankers to take). A key difference between Japan and the U.S. is that the USD is the primary global reserve currency, which is not true for the Yen. Thus, even if the Fed is neutral or hawkish for the U.S. economy at a 2% fed funds rate target, we don’t expect a long deflationary recession (or depression) like the one Japan experienced. The price of many U.S. goods, services, and assets that are not highly tradeable will fall–for example, today’s real earnings report shows that the price of hourly labor is falling, and home prices have been falling for some time. But global inflation is going to persist until the Fed becomes more hawkish, even with Jean-Claude Trichet’s ECB doing what it can to push down on global inflationary pressures at the expense of the European economy. 

The bottom line? We expect continuing stagnation and stubborn inflation; stagnation + inflation = stagflation. Again, at this point we don’t expect it to be as bad as in the 1970s, but it ’s still going to feel pretty crummy. Today’s numbers help drive that point home.