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 Because yesterday’s news is already way of out of date.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.