Friday, November 19, 2010

Why Inflation Should Not Be The Central Concern Right Now

James Picerno, author of Dynamic Asset Allocation, writes that those who say that rising inflation is currently the central challenge are ignoring the data. He points out that core CPI's pace continues to decline and headline inflation's annual pace has been moving sideways since June. See the following post from The Capital Spectator.

Yesterday's update on consumer price inflation for October offers few reasons to think that disinflation has been banished. That means it's too soon to dismiss the risk that deflation may turn into outright deflation down the road. That's probably a low risk, thanks to the Federal Reserve's monetary stimulus efforts. But it's a risk that's not yet low enough to send this potential pitfall to the museum of irrelevant economic hazards. In a world struggling with unusually high levels of debt and weak growth, deflation still can't be ruled out.

Quite simply, the inflation trend isn't our friend. Sure, everyone likes lower prices, or at least consumers do. But the general decline in the pace of inflation is increasingly worrisome in an economic climate that remains sluggish. The core measure of the consumer price index (CPI) rose at just 0.6% over the past year as of last month. That'd be fine if core CPI stayed at that level. But as the chart below shows, core CPI's pace (red line) continues to fade.

The core reading of inflation strips out food and energy prices. Why do that? Aren't food and energy prices key factors for consumers? Of course. But food and energy prices change easily and quickly. As such, factoring in these two volatile elements can distort the longer-term inflation trend. As an example, take another look at the chart above and note that headline inflation (blue line) was rising in 2007 and the first half of 2008, giving the impression that inflation was exploding to the upside.

Core inflation, by contrast, suggested that broad pricing pressure was less threatening, and it turned out to be correct. In fact, there's a fair amount of economic research that finds core inflation is a better measure of analyzing clues about pricing trends over longer periods. That includes the evidence that the wide differences in headline and core inflation tend to narrow over time. The short-term noise of headline inflation, in other words, has a habit of balancing out eventually. That's not terribly important for Joe Sixpack, but it's valuable information for central banking and setting monetary policy, which influences economic activity and prices with a lag.

The question before the house is whether the balancing will take place via higher core inflation or lower headline inflation in the months and years ahead? Headline inflation's annual pace has recently been moving sideways in the low-1% range since June. Is this a sign that inflation has stabilized at a relatively low level? If true, that'd be welcome news on a number of levels. It would also undermine the case for arguing that the momentum in disinflation via core CPI remains a clear and present danger.

Predictably, minds will differ. But arguing that rising inflation is the central challenge now, today, this minute, requires ignoring the data, or dismissing it as erroneous.

"The data is definitely in the Fed's camp today and should help keep the Fed's critics at bay," Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubish, said yesterday after the CPI report was released. "There is nothing in this data that would push the Fed off its course of continuing to buy government securities. Inflation is getting closer to becoming deflation and the recovery in housing seems to have been aborted," he explained via AP.

Eric Rosengren, who heads up the Boston Federal Reserve, offered a similar analysis yesterday in a speech at the Greater Providence Chamber of Commerce. He asserted that if inflation falls with short-term nominal interest rates stuck at just above zero, this amounts to a rise in the real rate of interest:

A decline in the inflation rate when interest rates are fixed amounts to monetary tightening. Given the state of the economy, a monetary contraction right now is both unintended and undesirable. So we want to prevent any further disinflation – not only because it gets us closer to a harmful deflationary situation, but also because it represents a monetary tightening when conditions are indicating that further accommodation is desirable.

If the federal funds rate was not close to zero right now, the arguments for reducing it – that is, for easing in monetary policy – would be quite strong. However, the federal funds rate is quite close to zero.

Thus the case an expanded round of monetary easing through purchases of Treasuries and other securities—a.k.a. quantitative easing. Again quoting Rosengren…

Are large-scale asset purchases (LSAP) a fundamentally different policy, either in intent and mechanics? The answer is no, LSAPs are much closer to traditional monetary policy than many commentators assume. We simply move in other markets than the federal funds market. And, like traditional monetary policy actions, we’re not talking about “bailouts” or stimulus spending or placing a debt burden on future generations. Let me explain.

In more normal times when the FOMC wants to ease monetary policy, we buy Treasury bills and, in paying the sellers for them, we create additional bank reserves. By making more reserves available to the banking system, we ease conditions in the overnight market for funds – the federal funds market – so the primary impact of these purchases is a reduction in the federal funds rate. But more importantly for the economy, we expect the reduction in the funds rate to over time translate into declines in mortgage rates, corporate bond rates, exchange rates, and a rise in stock prices – all of which of course help stimulate economic activity.

Now that the federal funds rate is near zero and the reserves in the system are quite large, the usual course is not an option. Instead of relying on the indirect effects of targeting a lower funds rate, we are opting to more directly affect the interest rates that have the greatest connection to real spending; by buying Treasury bonds and creating additional bank reserves. Since there are already substantial reserves in the system, the primary expected effect is lowering the long rate by purchasing a significant amount of longer-term Treasury bonds. Like conventional policy, one would expect that mortgage and corporate rates will fall, and exchange rates will be impacted, providing additional stimulus to the economy. That is in fact what has already happened…
Yes, but as we noted yesterday, QE2's big test is upon us. Even under the best of circumstances, QE2 isn't a silver bullet that magically repairs the economy. It's one policy tool and it arguably deserves to be applied now. Deciding how much of a positive impact it has is something else.

The frontline in deciding if it's working, and to what degree, arrives monthly in the inflation report. Based on yesterday's update, however, the case for thinking that the disinflation trend has been arrested is, at best, a mixed bag.
This post has been republished from James Picerno's blog, The Capital Spectator.

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