We’ve come across some good pro and con pieces regarding the issue of inflation, which we’ve linked below. While inflation expectations have come in quite a bit recently, the argument remains unsettled, and in our opinion, the outcome will depend heavily on growth rates and financial activities outside of the U.S. in coming years.
That said, it is critical to keep in mind that whatever the nominal rate of inflation, its impact has to be assessed in real terms, meaning relative to the direction and rate of change in other important variables. For example, if inflation in Country A is running at 10%, but nominal incomes are rising at 12%, then real incomes are growing 2%. Ignoring the mechanics and potential social fallout of such a process, that’s rather positive. However, if inflation is running at a tame 2% in Country B, while nominal incomes (or asset values) are falling at 2%, then real incomes (or real wealth) are declining at a rate of 4%, which has some fairly dire implications. So yes, the "inflation is not a concern" crowd can point to "benign" core U.S. inflation readings, but they can’t ignore the continuing deterioration in U.S. employment and asset markets, which are going to make the real impact of low nominal inflation much less benign than it would otherwise be.
We believe the ratcheting down of inflation expectations is due to several factors, including falling global growth rate expectations, continuing hawkishness of the ECB (both the ECB and the Bank of England kept overnight rates unchanged yesterday due to inflation concerns), the tendency of spot commodity markets to overshoot changes in inflation expectations, and perhaps most importantly, the belief that fresh liquidity provided by the Federal Reserve’s new auction facilities is being effectively offset by a committed defense of its fed funds rate target. This seems clear enough from Federal Reserve statistics. For example, see chart 3 on page 29 of this paper by Spence Hilton of the New York Fed. But Hilton’s chart 4 shows how volatile fed funds open market operations have become, which is indicative of both financial strain and a highly challenging environment for the Fed’s Open markets desk. Even more interesting is this chart from Cumberland Advisors which shows that when off balance sheet transactions (presumably related to Maiden Lane, LLC, the funding vehicle for J.P. Morgan’s takeover of Bear Stearns after its mid-March collapse) are taken into account, the Fed’s balance sheet has expanded by roughly 22% year-to-date. It’s not clear to us what impact the Maiden Lane assets will have on the domestic monetary base, if any, but at the very least, these images show how mch more challenging and complex the Fed’s job has become.
Here’s a thoughtful post by inflation hawk James Picerno, as well as a more dovish piece from Northern Trust that Picerno linked to in another post. Morgan Stanley has an interesting analysis of the G-7 economies that agrees with our prediction of a mild but persistent stagflation in coming years. And finally, Brad DeLong, an influential figure in Democrat policy circles, has penned another piece articulating the conventional Keynesian notion that until a "wage price spiral" occurs, inflation and inflation expectations should remain well contained:
In brief, the major central banks on both sides of the Atlantic have responded to the financial crisis, but they have not overreacted. Even with their liquidity injections, the fallout from the financial crisis has eliminated the risk of a wage-price spiral that might otherwise have arisen.
Yet headline inflation is soaring, and, not surprisingly, gets the headlines. This reflects three developments. First, the world has, for the moment at least, reached its resource limits, and we are seeing a big shift in relative prices as the global economy responds appropriately by making labor and capital cheap and oil and other resources expensive. The result of this relative price shift is headline inflation.
We’re still highly skeptical of these arguments as laid out here. As Robert Mundell has pointed out, Keynes’ ideas and his successors’ were developed during the Great Depression and World War II, when most of the world’s economies were autarkic, i.e., not integrated with each other and largely closed to trade and financial integration. While the wage price spiral is a sound construct for a closed economy, the only closed economy nowadays is the global one. That means that as long as there are no wage pressures globally, inflation expectations should indeed remain moderate. But one need only look at the rise in wage pressures in fast growing parts of the world to realize how shaky that prediction is***. And if rising global incomes support headline inflation for long enough, then eventually core price levels around the world will be pulled up to headline levels, rather than the more typical scenario where the headline inflation rate oscillates above and below a fairly stable rate of core inflation.
DeLong continues (emphasis added):
…inside the US, the return of the dollar toward its equilibrium value is carrying with it import price inflation. Costs to US consumers are rising and making them feel poorer, not because they have become poorer, but because the previous pattern of global imbalances exaggerated their wealth. Global rebalancing is painful for American consumers, and shows itself as higher headline inflation. But to respond by fighting inflation inside the US would be grossly inappropriate – both much more painful for US consumers and pointless.
We agree with most of what he says in the boldened statements. U.S. consumers have levered themselves up on unrealistic expectations of asset appreciation and/or future income. And fighting inflation would indeed make the process of adjustment more acutely painful. However, we would add two important observations. First, the recent and expected direction of federal policies since 2007 has certainly not supported the expected value of most assets or income. And second, we cannot escape the fact that the USD is still the world’s primary reserve currency, which makes using monetary policy to "manage" the domestic economy a rather complicated affair. For example, when the Fed eases in response to domestic slowing, it often creates inflationary pressures abroad, as in the 1970s and the current decade. When it fights inflationary pressures domestically, it often creates deflationary havoc abroad, as in the early 1980s and late 1990s. Ideally, the world’s primary central bank manages its currency with an eye on the global economy, and the tradeoff for this burden is that the country of issue gets to enjoy the privileges and benefits that accrue to the main supplier of global reserves. But when our actions tell the rest of the world that we’re unwilling to bear the occasional cost of those benefits–as some, like Mundell, argue the Federal Reserve has done since its inception 95 years ago–then we have to wonder how much longer the world will be willing to grant those privileges to
the USA. That’s an even more compelling question when you consider the emergence of the Euro, and the unavoidable fact that the U.S. economy will continue to produce an increasingly lower share of global output. In other words, there was a long period of time in the 20th century when U.S. monetary authorities could behave as if they didn’t give a fig about the rest of the world. But that time is inevitably drawing to a close, and if we continue to pursue monetary policy with "asymmetric adjustments"–where we seek to reap the benefits of being the world’s primary monetary issuer, but shift the costs to regions, countries, and people outside the U.S.–it will come to an even quicker end.
DeLong seems to recognize this problem in his op-ed, although his solution is a mandarin one of trade and monetary negotiations, especially with China. That’s fine, but it doesn’t address the growing problem of slow or negative growth in developed economies. For that, we need to invoke Mundell’s optimal policy mix of lower barriers to saving, investment, and (eventually) growth, along with stronger monetary policy. It would require some fiscal discipline by the federal government, which might be a pipe dream at the moment. But such a mix would undoubtedly raise expected asset values and incomes at the margin, and those would in turn allow the U.S. consumer to continue de-levering with less overall pain to the U.S. and global economies. Unfortunately, while there are a few voices in Congress advocating such a path, we don’t see such a policy mix on the immediate horizon.
*** On a related note, DeLong may not have considered the details of the contract currently being negotiated between Boeing and its machinists, which will provide a wage increase of 11-13% (Boeing’s offer and the union’s demand, respectively). There were some other compensation concessions demanded and offered as well, with the only sticking point being the use of outside contractors. That certainly indicates an upturn in union bargaining power, which doesn’t surprise us given (a) political trends of the last two years, (b) the historically large share of GDP that has accrued to corporate profits over the most recent business cycle, and most importantly, (c) rising cost of living pressures, thank to rising headline inflation and falling employment, a/k/a falling real incomes. We are witnessing the actual process by which headline inflation eventually leads core inflation higher. And lest we forget, home and other U.S. asset prices took a beating in the midst of the stagflationary 1970s, but inflationary pressures didn’t peak until several years later.
Uncategorized | art September 7, 2008 | 
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