Tuesday, February 20, 2018

Inflation is Roaring Back

A picture is worth a thousand words. Right?

I guess you can answer that question. At the heart of current discussions about the US economy is whether or not the inflation monster has awakened from its long nap and is about to devour us. Since the future is all about the future and only the Great Tuna knows the future, the rest of us can only make silly statements and forecasts about it. So in that spirit I thought I would ask Fred to draw a picture that we could gaze upon.

But before we gaze, let me try to summarize the issues. The US economy is stronger as evidenced by a low unemployment rate, tighter labor markets, rising wages,  higher inflationary expectations, and higher actual inflation. While most of that sounds lovely and juicy like a large steak au poivre, apparently people who own things like stocks and bonds were scared out of their bejeezers by this story. When hearing this information from Charlie Sheen, they sold their stocks like a new shipment of socks in Venezuela.

Another way of saying this is that we are in a new epoch in which good news is bad news. A strong economy apparently means a weak economy. A strong economy with promises of better profits and higher incomes means something horrible is going to happen. Are we supposed to hope for bad news so that will mean better future outcomes? To be less sarcastic, the false news being spread is that a strong economy and tight labor markets mean that wages and prices will grow too fast -- with the buying power of the wages being eroded as productivity peaks and falls. In the meantime, the Fed will react by raising interest rates and somehow moving interest rates up a few notches will cripple the strong economy. And then the rise in government deficits will pile on the parade by causing even more inflation.

Don't you just love macro? You don't have to answer that.

So there we are as we gaze at the chart below. I graphed two series -- the red line is the CPI. The blue is earnings of workers in the private sector. Each is monthly data from 1970 to the end of 2017. I graphed the growth rates of both series -- each represents the percentage change in that month relative to the value in that month a year before. Thus the data points are monthly but they are smoother than taking the percentage change from one month before. Some of the month-to-month craziness or variance gets removed and lets our eyes focus on more persistent or durable changes.

The reason for graphing these two series over a long period is to gain some perspective on the more recent changes. For example, look at the red line (inflation) since 2015. It is clearly rising indicating a rising inflation rate. Notice that the blue line (workforce earnings) shows no such increase. In fact, the wage line has been generally falling and flattening since about 1997. Thus, the very clear uptick in inflation does not seem to be caused by anything happening to wages. Perhaps inflation is being impacted by oil prices or the price of Donald Trump's hair cuts. Or maybe inflation got tired of being so low. The rise seems large only in relation to the very low rates after the last recession.

One clear thing in the chart is that inflation and wage gains often accelerate before a recession. The grey bars indicate recession years. Before most of the recessions wages and prices did accelerate and that was mostly because the economy was growing at unsustainable rates. Notice too that it often takes several years of rising inflation and wages before bad things start to happen.

Also notice from the chart that we do not know when the next recession will start and clearly we know that the economy has not been rising at unsustainable rates. Much of the writing in the last years laments that the economy is growing too slowly. But these things can change and we are right to wonder if the economy will grow faster, wages and prices will careen upward, and a recession will follow. It is right to wonder. But it seems crazy that such a possibility makes us crazy. Crazy enough to cause a stock market collapse.

Graphs are food for thought. I pointed out a few things from the graph. What about you? What does this graph whisper to you? Is inflation on its way to scary levels?

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