Tuesday, May 21, 2013

Inflation History Lesson: From the frying pan to the fire and back again

Cartoon By Jim Gibson

Inflation is back in the news. While there are a few folks worried about rising inflation much of the energy has been focused on it falling (often called disinflation). The latest news on inflation in April showed it negative, -0.4% in April after -0.2% in March (a negative inflation rate means prices are falling and is often called deflation). Consumers generally like inflation to fall, so this is good news for them. It was also cheered by asset holders because lower inflation means the Fed has more room to pump up the economy. Of course, if disinflation or deflation continues, many will take this as a sign that the economy is once again going into a recession. And that is not good news.

So here we are. As usual we have a difference of opinion. Some experts are worried about the inflation rate rising while others are worried it is going to fall. While the past is never a perfect guide for tomorrow, it doesn’t hurt to review what the data shows us. And what the data shows is disconcerting. While inflation may well fall more in the near future there is every reason to bet it will come back with a vengeance. This data came from Fred at the St. Louis Fed. Fred is a handy-dandy free data and graph service. http://research.stlouisfed.org/fred2/

The graph below plots annual values of two measures of US inflation from 1959 to present. One measure is based on the well-known Consumer Price Index for All Urban Consumers. The second one is drawn from the less-well-known Personal Consumption Expenditures Deflator Excluding Food and Energy. Inflation rates are created by taking annual percentage changes in these indexes. Because these index names are long and ugly I am going to called them Steve (blue line in the chart) (like in Steve Martin who is wild and Crazy) and Angela (red line in the chart) (as in Angela Merkel who is not wild and crazy).

Steve inflation is published by the US Labor Department and is based on surveys of prices paid by the typical urban consumer. Steve inflation often swings wildly because food and energy are important parts of Steve and these prices can gyrate like Britney Spears after a night on the town. For example the graph shows Steve inflation rising to about 14% in 1979 only to fall back to about 3% within a few years. Much of that was attributed to food and energy. Not that food and energy prices don’t affect consumers – but they do distort what is happening to the prices of what most of the consumers buy. 

That is why I added Angela inflation – she is constructed and published by the US Commerce Department as a tool to deflate personal consumer spending. Angela is a little more boring because the Commerce Department has removed those pesky food and energy prices from this version of the PCE deflator. (This index also makes an attempt to remove some of the bias caused by Steve’s assumption that people do not economize on goods and services whose prices are rising the fastest.)

So that’s Steve inflation and Angela inflation. A quick look at the chart shows that Steve swings around like a young lady at a ho-down in Arkansas. Angela is more conservative and I must conclude – much more refined and reliable. Some might say that Angela is smoother! But notice too that Angela and Steve have the same general tendencies or trends. So while they might disagree on the extent of inflation during a particular year or two – they both agree on the general direction of inflation. Notice that from 1959 to 1979 they both were rising and thereafter falling. You might say that the most current trend of inflation was to flatten at a little less than 2.5% starting in about 1990.

Apparently what goes up must come down. As we think about where we are today and what will come tomorrow it is good to see these trends. But they are only part of the story. For example, you might want to extend the downward trend since 1979 into the future. That would argue against a quick return to higher inflation. Then again, you might think that 15 years of falling inflation is long enough for the trend and therefore you might want to predict a reversal of trend. In that case you are worried about rising inflation.

There is more to see in this graph. Notice the vertical shaded areas – they depict recessions. We have had eight recessions since 1959. After seven of those eight recessions the inflation rate fell. That makes economic sense. Recessions are times when buyers slow their purchases and firms find it more difficult to sell goods. They often discount their prices to get rid of excess inventories. These disinflation periods following recessions can be very shallow and short (e.g. after the 1970 recession) or they can be much longer and more pronounced (e.g. after the 1980 recession). After the 1990 recession the inflation rate fell for almost 10 years.

Now look at inflation behavior before each recession. In all the recessions except for 1982, the inflation rate was rising before the recession started. In all those cases you had sharp changes in Fed policy – increasing interest rates to try to cool off the inflationary economy. But as soon as the recession was evident, the Fed reversed engines and reduced interest rates. In one sense the policies worked – you can see that inflation did fall. But the unintended consequence of the tight money policy was a recession.

So what do we have? We have inflation rising followed by tight money followed by inflation falling followed by loose money followed by rising inflation. This cycle goes on and on. The prudent thing would be to bring monetary policy back to neutrality once the worst of the recession is over. Why? To answer that question we have to look into what caused the pesky inflation to begin with. The graph shows that food and energy prices must have had some impact driving overall inflation upwards – especially in the 1970s. But food and energy prices do not explain the upward thrust of inflation that occurred in in the late 1980s, late 1990s, and then again after the turn of the century.

Fed policy had very much to do with driving inflation periods higher after those recessions. This belief is based on policy data. I used the level of the federal funds rate (ffr) as my measure of monetary policy. When the Fed wants to tighten policy they raise their goal for ffr; when they want to loosen money they reduce the ffr. So here is what I found:

·        The 1982 recession ended in November 1982. The ffr went from 15.1% in early 1981 to 6.6% in March of 1988. In other words – the Fed kept monetary policy very loose more than six years after the end of the recession.
·        The 1990/91 recession ended in March of 1991. The first quarter of 1989 had a ffr of 9.8%. It was reduced until February of 1994 to the point where it was 3.3%. Again the ffr was kept very low until three years after the end of the recession.
·        The 2001 recession ended in November of that year. The ffr was about 6.5% at the end of 2000 and continued down to 1.8% until November of 2004 – three years after the end of the recession.
·        Finally the 2008/2009 recession ended in June of 2009. The ffr started at 5.3% in mid-2007. It started down and has remained at 0.25% as of today. Today is now four years after the recession. It is unclear when the Fed will again begin the raise rates.

What is the history lesson? The Fed is an aggressive agent for monetary policy. It strikes hard at rising inflation and tries to offset recessions. But it also has a tendency to be very late when it comes to withdrawing monetary stimulus after recessions end. After the last four recessions, the Fed was late when it came to leaving the dance. They left four years late! They are still dancing some four years after the last recession.

Why not stay at the dance? The answer is in the data. Monetary policy eventually revs up the economic engine. Recessions do not last forever and the economy returns to strength. Always worried they didn’t do enough, the Fed keeps the stimulus going for too long and the result is – higher inflation and then a need to fight inflation again. And then another recession.

To my scientific friends – I know a graph or two does not constitute real scientific proof  of anything. Someone else might be able to manipulate data that shows a fuzzier result. But I have been reading the literature and watching the economy for decades. I don’t think you can deny the fact that the Fed can best be described by the old adage -- from the frying pan into the fire and back again. It is time for the fed to reduce monetary stimulus and forestall the usual recession-inflation-recession nightmare.


  1. In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.
    - Alan Greenspan

  2. Dear Fuzz -- it just ain't so. The gold standard did not protect us from inflation and leaving it at least twice -- most recently the Gold Exchange Standard in 1971. Politicians have shown a remarkable ability to destroy value with inflation with or without a gold standard.