Inflation Watch

Some people think deficits cause inflation; some don't. I'm in the latter group, because I think inflation is almost always a result of monetary policy, and seldom if ever of fiscal policy.

But whichever it is, the numbers should start swinging one way or the other reasonably soon, given the unprecedented deficits we're running (...and will continue to run for several years). Either deficits will pull away from the low inflation numbers, or the inflation numbers will start rising with the deficits. It might be a good idea to start watching all the key numbers in one place on a regular basis, so here they are:

The CPI says we're deflating; the other three say we are safely in low-inflation territory.

Another way of saying that: all four indicators say that inflation is not a problem yet. Neither the deficits we have, nor the deficits we know are coming, nor the trillion dollars the Fed has "printed up" are causing any inflation so far. Why? In my judgment, deficits don't cause inflation, so that narrows the mystery down to all that money the Fed printed up. Reason that's not causing inflation yet is because almost all of it is just sitting there, in "excess reserves" in the banking system. (If the Fed printed up a *hundred* trillion dollars and set it down in an inaccessible nook at the bottom of the Grand Canyon, that wouldn't be inflationary either.)

So here's this week's conclusion:

Nothing but a low, safe inflation level so far. If the high-inflation demon is out there, it's still hiding just around the next corner, as it has been for the several decades I've been paying attention.

============

End note regarding the four inflation indicators I picked:
My two personal favorites are the so-called TIPS spread, and the "trimmed-mean" PCE. The TIPS spread is the worldwide bond market's daily judgment on inflation, and the most popular "spread" is the difference between the interest rate on 10-year Treasury notes and the rate on 10-year Treasury inflation-protected securities. The trimmed-mean PCE is the Dallas Fed's massaging of the components in the personal consumption expenditures numbers, and it's a second cousin of "core" PCE.

The Consumer Price Index (CPI) is a must have because it's always in the headlines. The GDP deflator is a bit more comprehensive than the others, but it's also more delayed (...it's more of a rear-view-mirror indicator).

Here are the links to the sources:

Trimmed-mean PCE

TIPS spread components:
 10-year T-Notes, daily
 10-year TIPS, daily

CPI-U

GDP deflator

Comments

[Gil]

I s'pose your polar opposite might be Peter Schiff. Why do I get the feeling that in some twenty years time the world (including the U.S.A.) is alive and well? That the Peter Schiffs of the world will still be forecasting doom&gloom and every economic downturn will be 'the one'?

[Bob]

Why not include the PPI or some of it's relevant components? Seems to me that it would be indicator if potential price inflation in the pipeline.

Isn't it a little early to start worrying about inflation? High unemployment rate, commercial property rents falling (and increasing vacancies), vehicle sales in the tank, etc.

[SkylightMT]

Off topic a little, but (maybe I'm just too young to know) it seems like our inflation/deflation is different from previous concerns in similar situations.

We're not seeing inflation anywhere but where it matters to us blue-collar types: gasoline and food. We used to feed our family of 3 on $45.00 a week. In the last few months that has become impossible - its more like $70.00 a week on a good week.

Is there such thing as split-inflation? Is it possible for non-essentials to deflate or minimally inflate while essentials greatly inflate?

[jpniner]

if Inflation doesn't come, it needs to be used to bury Peter Schiff and company.

That may seem unfair, but he is regarded on the Internets by the Paultards as some sort of god now and has 'proven' to them they are 100% correct on all things economic.

Perhaps you've seen the videos were he predicted the Housing bust(he didn't mention the CDS component..)....You could make similar videos of his calls for massive inflation being completely wrong, but they of course will not do that.

[Optimist123]

"Peter Schiff predicted a collapse of the U.S. financial system. The bust-up he didn't foresee was the one that made mincemeat of investors who took his advice in 2008..."
http://tinyurl.com/aj4mhs

[Mike Sproul]

Deficits cause inflation when the deficit causes the value of government bonds to fall, and the central bank holds those bonds as backing for the money it issues. Monetary policy causes inflation when the quantity of money issued by the central bank outruns the assets held by the central bank as backing for the money.

[jpniner]

Mortgage have skyrocketed in the last day, 30 yr Bond is too....sign of inflation to come?

[Optimist123]

Could be, but from what I read it's more likely a sign that the housing market won't recover as soon as the Fed (and everyone else) would like it to -- and that is not an inflation signal.

[jpniner]

Wonder how many home builders go under in the next 12 months?

[Jim Glass]

Deficits don't cause inflation -- monetizing deficits because you don't have the discipline to pay the tax cost of carrying the debt they create causes inflation.

A warning from John Taylor, of "Taylor Rule" fame, an economist who knows about fiscal policy:

http://www.ft.com/cms/s/0/71520770-4a2c-11de-8e7e-00144feabdc0.html?nclick_check=1

[Optimist123]

Hi Jim,

John Taylor can apparently be confusing. This April 27 article in the FT says that, according to the "Taylor rule" the ideal interest rate is MINUS five percent:
http://tinyurl.com/d5zure

If that's still a good number, it means that the Taylor Rule says the Fed is 520 basis points too tight at present. That's deflationary.

[Bob]

Steve,

I read both articles re: Taylor. My take is that there is congruence in terms of monetary policy but not fiscal policy. In other words keep the cost of borrowing real low but rein in the government spending. Apparently he's concerned that the stimulus will be more permanent.

[Jim Glass]

Hi Steve.

I see zero "threat" of inflation now. While I would hardly presume to speak for Taylor, I doubt that he does either.

That's probable bad, because a credible threat of inflation returning would mean the crisis is over. As long as the Taylor Rule interest rate is multiple points negative, ouch, the current danger is all the other way. All the quantitative easing is meant to deal with that.

Taylor in that piece is warning of the future effects of the zooming up national debt. He's in the camp that thinks Obama has made the future now, debt-wise -- in that the national debt as a percentage of GDP was projected shoot up without end starting circa 2016, but now Obama's planning to double it *by* 2016, so the projected shooting up without end has already started.

Taylor mentions the warning Britain just received on its credit rating -- but he doesn't mention that both Moody's and S&P have projected the US national credit rating to start falling in 2017 ... and they did that *before* Obama decided to double the national debt as a %-of-GDP by then.

[Optimist123]

Jim,

It's difficult to argue with Taylor, so I'll just contribute my standard peeves after summarizing where I agree.

Yes, long term deficits can be too high and therefore unsustainable. Yes, there are "only two" ways to decrease an unsustainable deficit: (1) raise taxes, or (2) decrease spending. I agree with all of that.

My peeves: Almost everybody has chosen sides ideologically, and their minds are made up as to how to make their side's economic case. John Taylor's side says "cut spending"; Obama's side says "raise tax rates on the rich."

Fine. They are effective sound bites, and they fit on bumperstickers. But that's a political end, not an economic one.

But getting back to the the "only two" ways to fix a too-high deficit. Number one is ambiguous; it should be separated into its two components, as follows:
(1a) raise tax rates; or
(1b) raise tax receipts *without* raising tax rates.

If we can be sufficiently successful at 1b, it doesn't matter how much debt we have (by definition of "successful"); yet John Taylor talks as if reducing the debt by reducing spending, is the only correct way to fix the problem. That's the right's mantra. The left's ill-thought-out fix is, of course, their mantra of imposing (1a) on the social classes of their choice.

Now I'll use some extreme numbers just to illustrate my peeve. I'm wondering what John Taylor would think of a future US economy "saddled" with $110 trillion debt (...10x today's level; remember, he's against "too much" debt) -- a point we reached because we never took his advice to "cut spending." Oh, and one other thing: it's a $220 trillion economy that's "saddled" with all that debt. I'm guessing he wouldn't mind that economy one bit; therefore, because he seldom if ever talks about how to better grow the denominator of debt/GDP, I have to assume he simply takes some level of growth (say, 3%) for granted. In other words, growth is exogenous; it just happens; we can't do anything about it.

The left comes to that same implicit conclusion in their own superficial way. "Growth just happens."

That's my peeve. Paul Romer achieved fame (and may someday win the Nobel prize) for challenging the growth-just-happens premise in a very big way: "Endogenous Growth" is his contribution to economics. Growth does NOT "just happen"; it DEPENDS on other things we do, things that enhance it or retard it. Growth is a DEPENDENT variable.

Solution (1b) depends on enhanced growth; but the dogma on both sides IGNORES (1b). "Cut spending" and "tax the rich" are just about all I ever hear as solutions to unsustainable deficits, even from people like John Taylor.

If I could ask him one question, it would be this: "If at some future point, the US economy reached a size of $500 trillion in today's dollars, with $200 trillion federal debt, what would you think of that debt level?"

I'm guessing he wouldn't judge that debt level to be disastrous. At which point, I would have a few hundred follow-up questions at the ready.

[beancounter]

An interesting tidbit I thought I would like to share:

http://tinyurl.com/mvpfrs

"Economists call this phenomenon "job lock," and studies suggest that it keeps between 20 percent and 50 percent of workers from leaving their current jobs.

Because health insurance is tied to employment in the United States, workers who leave their jobs can see health bills skyrocket if they strike out on their own or take a position with a company that offers fewer benefits. Workers who would like to retire early stay on, unable to qualify for the government's Medicare program until they turn 65.

And those who have existing health problems may not be able to get coverage at all."

20-50% of people unable to leave their jobs? Sounds like an economic disaster in the making. That 20% could easily be the few percentage points growth that would make a difference between a recession and a boom. Some will discount this, but I tend to believe common sense arguments in economics -- that entrepreneurs will be unwilling to leave hundreds of thousands of dollars in group health insurance and group benefits -- than "moral hazard" arguments or "nanny state" accusations. If GM can't bribe workers to give up their health insurance with 140k, human nature may favor some form of common health insurance for maximum growth.

[Mike H]

I can't draw any conclusion from this, but tonight on Kudlow, Taylor himself said that he thinks the target rate is 0.5%. Wonder which assumption is different between him and the Fed that caused his equation to give him such a different result.

[Optimist123]

Mike H:

I suspect it's due to a difference of opinion as to what numbers should be plugged into the "Taylor rule" equation ( http://tinyurl.com/mvsqva ).

We can listen to John Taylor himself explain the Taylor rule at this link:
http://tinyurl.com/6b86nv

...but I listened to it twice and was still confused about a couple things. The GDP deflator is the most lagged measure of inflation we have. Should we lead or lag any of the other components to compensate, given that it takes 12+ months for a change in the Fed funds rate to start affecting the inflation rate? If so, who gets to "guess" what inflation will be 12+ months from now, given a Fed funds rate change today, and what is their track record at guessing so far? And isn't there some circular logic at work in that?

And what if the GDP growth rate is dependent on something besides its own trend? (In fact, that right there seems to be evidence that Taylor assumes GDP growth to be exogenous.)

Bottom line: No wonder there's disagreement.