Which is it: Inflation, Disinflation, or Deflation?

A lot of experts (most of them ex-governors of the Fed) are insisting that the Fed should lower their target fed funds rate, and many of them are saying the Fed should do it now instead of waiting until its next meeting on Sept. 18.  After looking at the two charts below, I can see why they are so insistent. 

First is the latest version of the inflation chart I've been posting periodically, showing two versions of the inflation rate on Personal Consumption Expenditures (PCE), and also the inflation rate perceived by the buyers of 10-year treasury notes.  All three measures imply that inflation is not just falling, but plummeting.  That's disinflation (...and, if and when it falls below zero percent, it's deflation.)  Click to enlarge:

Based on that chart, it looks as if we now have disinflation (a falling inflation rate) in consumption goods.  But the pundits are also pointing to falling asset prices (houses) that may be a precursor to more downward pressure on consumption goods prices.  That's a double-whammy, and it's the reason several ex-governors are clamoring for a reduction in the fed funds rate soon.  They do have opponents who say a reduction is premature or unnecessary; however, I'm with those calling for a reduction.  Reason: I have a strong dislike for inflation, and an even stronger dislike for deflation.   

The Fed's primary job is to maintain a stable value for the dollar.  That's nearly unanimous; the few who disagree seem to think the Fed's job is to maintain a stable supply of dollars, as opposed to a stable level of purchasing power for the dollar... but even the Fed Board of Governors says the first of its four duties is the pursuit of "stable prices"—not "stable money supply" (see The Federal Reserve System: Purposes and Functions).  Not only is the dollar not stable when it is inflating unexpectedly, it is also not stable when it is deflating.  Unexpected inflation hurts lenders (eg, banks and savers), deflation hurts borrowers (eg, businesses and entreprenuers), and both conditions hurt the economy.  The Fed exists to prevent both situations, if it can.  To prevent the pain of inflation, it typically increases the target fed funds interest rate; to prevent the pain of deflation, it typically decreases the target rate.  [Because the Fed cannot lower its target below zero, it needs room to maneuver, and that's one big reason why its target rate is usually in the 2% range.]   

Another of the Fed's four duties, by the way, is "maintaining the stability of the financial system and containing systematic risk that may arise in financial markets."  And that brings us to the second chart, showing what looks mysteriously like an unannounced rate reduction by the Fed (see white line). 

The target rate is still 5.25% (green line); but the Fed's open market actions have managed the actual result (white line) to 4.92% average since mid-August.  I strongly suspect the liquidity crisis two weeks ago, plus the market's flight to the safety of short-term US Treasury bills (possibly still in progress), go a long way to explaining why.  I'm just wondering if it's a signal that the Fed will in fact lower its advertised target rate one day soon. 

It looks like a duck, and it walks like a duck; maybe the Fed should start calling it a duck. 

In any case, the stock market has already priced a Fed rate cut into stock prices, according to many of the pundits.  If the Fed does not do it by Sept. 18, I'll be surprised at that—but I wouldn't be surprised if the market then reacted with an immediate nosedive. 

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Source data:
• Inflation rate, PCE
• 10yr T-notes
• 10yr inflation-protected treasuries
• daily fed funds rate
• 3-month T-bill rates

Comments

[Aaron]

I have a quick question on inflation. I do business with China and lately (last six months) we have seen major price hikes from suppliers due to raw material prices, RMB appreciation, and the removal of tax rebates. Does that affect inflation, or is that just "normal" increases in price?

[Kevin]

Aaron, inflation properly is defined by the prices domestic consumers experience at the retail level. (Which is what CPI attempts to gauge.) Sounds like you are a business or somewhere in the supply chain. The question is, are higher prices from China causing end-user products and services that consumers buy to go up?

Maybe not (due to retail competition) -- and suppliers are eating the extra cost instead. That is not inflation.

But, if China-derived consumer products are going up in price at retail, then that does contribute to inflation. Keeping in mind "inflation" refers to the GENERAL price level of ALL consumer goods and services. If just a few things go up in price it may not have a statistically significant impact.

[Aaron]

In my experience, the prices have been contained for several years by suppliers sucking it up, but now it seems like everyone has decided they cannot do that anymore and are releasing large price hikes all at once.

While I guess retailers in the US could take the hit, 20-30% price increases should mean 60-100% price increases at retail. With retailers margins being so low, and they already cut out the middlemen where they can, I am not confident they could take the hit this time.

[Aaron]

There is one factor that I could be ignoring: some buyers are attempting to move inland to cheaper Chinese provinces. I don't know if they are having price hikes or not.

[Bob]

I won't go on record that inflation is dead. However, it seems to me that the Fed has had too much concern about "spiraling" inflation - that which we saw in the late seventies and early eighties.

But times are so different now. How many companies are doling out COLA raises? About zero is my guess. And could not one make a case (anecdotal, at least ) that the boomers who came of age during the that time buying their first house, and furniture, etc. contributed to a supply/demand imbalance that is not likely to repeat?

Bottom line. Are the conditions, specifically demographics, that exist now or projected to exist different or the same than the past. ?

[mark]

Steve,
If OPEC decides to shutdown the pipeline (or maybe terrorist do the same) oil prices are sure to skyrocket. This will no doubt cause the price of just about everything else to go up. How does this Fed fight this "inflation"? Many of the business talk show host define inflation as a "monetary phenomenom caused by the Fed printing too much money", but what does the above example of inflation have to do with monetary policy?

[JBL]

One thing about the Fed dropping the effective fed funds rate without changing the official target rate is that the prime rate hasn't changed. The extra liquidity didn't immediately translate into lower costs for borrowers.

It hasn't exactly created a bonanza for banks, since the yield curve overall is still flat to inverted, but it's interesting.

One of the balancing acts the Fed has to play now is to let the bubble burst and take its course without letting the damage spread to previously healthy segments of the economy. We don't want deflation, but we also don't necessarily want to bail out those with too much leverage in artificially (or at least unsustainably) inflated assets.

The unusual rate structure may be an attempt to do that.

Or it might just be goofy. But if it works out like we're all hoping it will, Bernanke will deserve some credit.

[Kurt Brouwer]

Steve--Nice post. Your charts are great. I posted on it--with attribution, of course.

Aaron--the most recent rate of inflation in China was 5.6%. See here for more: http://fundmasteryblog.wordpress.com/2007/08/13/inflation-soars-to-56-in-china/