Is Inflation Back?

Is inflation coming back? Are hoola hoops returning? I don't really know since I still don't know how to predict the future. But people want to know answers to these kinds of questions so we devise ways to think about the future. One way is to hire a psychic or you could buy a Ouija Board.

In economics we resort to two well criticized methods -- we base forecasts on imperfect theories or take a walk through the data. While inflation theories can be quite complicated, many of us today throw them around like salmon at the Seattle Fish Market. The simpler the better. The economy is stronger than it used to be. Excess capacity is diminishing. Presto, firms can get higher prices for goods and services and inflation is higher. Job done. Way to go dudes.

Sometimes people or what we sometimes refer to as the "street" take these sophisticated theory-based forecasts seriously. Those very important people who comprise the Federal Reserve Open Market Committee (FOMC) take this information seriously and have announced that they have diverted their war against unemployment to a war against inflation. Or in more common layman's language they decided to raise interest rates four times this year.

When the Fed announces a plan to raise interest rates four times in a year that is big stuff. Some emerging markets suffered already as rich folks moved their money back to the USA in anticipation of jucier returns here. Some folks have decided to postpone their purchases of SUVs and garden condos because of higher interest rates. People who worry about inflation are now even more worried about inflation because the Fed would never lie. If the Fed is worried about future inflation then so should they.

While other parts of inflation theory would argue against a sustained rise in inflation, we ignore those irritating little details and sweep them under the rug. I have covered those points in recent posts and don't want to go over that today. Let's just say that most people seem to be clinging to a theory that predicts that strong US growth is going to raise inflation.

Today I want to play games with numbers. I chose to look at recent inflation rates. There are at least as many inflation rate indicators as there are SUVs. So one has to make a choice or write a 700 page dissertation. I chose the measure supposedly used by the FOMC -- the rate of change of the personal consumption expenditures (PCE) deflator. The PCE deflator is very much like its more well-know cousin, the Consumer Price Index (CPI), but it is a lot prettier and dresses better.

There is a version of the PCE deflator that ignores changes in food and energy prices. Food and energy prices are more erratic than a Trump behind a Twitter board. By ignoring F&E in an inflation measure, we focus on things that are less erratic and more sustained. Policy is supposed to ignore all those random fluctuations and focus on more sustained or persistent changes in prices.

I decided that since inflation of the PCE deflator less F&E has been rising for about 7 months -- I would focus on the 7 month annualized change in that index. Those numbers are found in the table below. I am comparing these 7 months changes over 7 month time periods since near the end of the last recession. Thus the table looks at inflation information from 2009 to 2017.

We begin the story by looking at the bottom numbers in the bottom of the table, 2.08 and .04. The 2.08 is the moving average of the inflation rate over the seven months from October of 2017 to May of 2018. Looking up that column you see its the highest number. Thus we see that inflation is higher now. The 0.4 says it was almost half of a percentage point higher than in the previous 7 month period. So that data shows inflation (PCE less F&E averaged over 7 months) is clearly higher.

Does the rest of the table tell us anything else about inflation that could be useful when thinking about the future? Notice that some of the rows of numbers are in red. In those rows the inflation rate in that 7 month period was lower than in the previous 7 month period. Inflation has not gone up linearly since 2009. It goes up and then it goes down. I chose 7 month moving averages because that time coincides with the latest increases in inflation -- and because it is a long enough period to be measuring sustained changes.

The point is that inflation has not sustained itself at higher levels since 2009. It bumps up and then it bumps down. Notice in 2016 there were back-to-back seven month periods when the inflation rose by .29 and then .44 points. Surely inflation was on a tear. But then those two periods were followed by  a seven month decline by .83 points. Hmm -- not so much a tear.

I'm not going to bore you with a discussion of all these numbers. But I do think that the two recent bouts of inflation from early 2017 to early 2018 do not prove that inflation is roaring back. Those two periods are not unlike what happened the year before and from what often happens in history after the inflation rate rises for a while.

There is no reason from either data or theory to be sure that inflation will come roaring back like a World Cup player after encountering what appeared to be a life-ending fall on the turf. I am happy the Fed seems to have ended its vendetta against unemployment but that doesn't mean they have to turn their guns on inflation. Just slowly return monetary policy to normalcy. That's all they need to do. Quit scaring the rest of us with your anti-inflation rhetoric. Extreme changes in policy from the frying pan into the fire can cause recessions. Here's a great idea -- let's have a monetary policy that goes from extreme to normal!

Personal Consumption Expenditures Deflator
Less Food and Energy 
Annualized Percent Change, 
Seven Month Moving Average

		7 Mo
		Avg	Change
2009	Aug	1.46
2010	Mar	1.57	0.11
2010	Nov	0.89	-0.68
2011	May	1.8	0.91
2011	Dec	1.7	-0.1
2012	Jul	1.93	0.23
2013	Feb	1.59	-0.34
2013	Sep	1.25	-0.34
2014	Apr	1.78	0.53
2014	Nov	1.43	-0.35
2015	Jun	1.3	-0.13
2016	Jan	1.59	0.29
2016	Aug	2.03	0.44
2017	Mar	1.2	-0.83
2017	Oct	1.68	0.48
2018	May	2.08	0.4

Lesson 18 Inflation

The posts in my blog space named “lessons” are meant to provide some background on concepts I throw around like fish at a Seattle fish market. Some of my readers are not economists, and they often send me emails requesting that I try to better explain macro concepts. I sometimes direct them to my online resource called MacroNotes (http://macronotesmba.com/ ) but that’s a little like sending someone who wants to taste a little pho to Hanoi when our local Vietnamese restaurant, Rush Hour Station, has perfectly good pho. So instead of going to MacroNotes for more information about inflation ( http://macronotesmba.com/lessons/inflation-and-unemployment/ ), I will post today on that topic.

Inflation isn’t an easy topic and therefore deserves some attention. And inflation is a very important topic these days for several reasons. First, it is growing slower in the USA and that makes us wonder about it. Second, it seems to be associated with economic growth forecasts that are less than rosy. Something is going on out there that makes lower inflation a sign and maybe even a cause of slower economic growth. And third, our policymakers see the lower inflation rates as a reason to keep pouring fuel on the economy.

Inflation will never be as exciting as a Confederate War Memorial or an Indiana University football game, but inflation is pretty interesting these days. So what is inflation?

Let’s begin with this definition: inflation is the rate of change of prices. For you math buffs, this definition is basically an equation. I can talk about the inflation rate of weed prices in Colorado. Suppose a sack of weed went from $2.00 to $2.20 in the last month. Applying the formula, we can say that the inflation rate of weed during that time period was 10%. Anything that has a price has an inflation rate associated with it.

Applying this concept of a rate of change means that inflation of something could be positive, negative, or zero. If it is negative then we call that deflation as it means prices are falling. If the calculation is positive then we simply call that inflation. If the calculation is zero we have no name for that. We would say inflation is zero. Once a teacher called me "zero" but that had nothing to do with inflation. 

We also have terms to describe how the inflation rate is changing over time. If the inflation rate goes from 2% to 1% we say inflation in decreasing or we say we call this disinflation. A rising inflation rate is called reflation.

The inflation rate we are discussing today is the inflation rate of a nation. In the USA each day, we not only buy weed but we buy silly things like cars and doctor visits and Uber rides. Our Labor Department defines someone called the typical Urban Consumer. Let’s call her Jaden. Jaden buys stuff each month at Target, Kroger, and of course Amazon. Since she is the typical Urban Consumer, the Labor Department tracks what she pays for all the goods and services she buys. She hides this information from Chuck but that is another story. 

The idea is that the Labor Department can get a number that represents what she paid for all the stuff she bought in any month, say for example, December of 2016. We would call that number the CPI for December 2016 for the USA. Let’s say that number is 200. We collect that same price information in January of 2017. Suppose the number for January turns out to be 210. We would use our formula and conclude that the inflation rate in January was 5%. If that rate kept up for every month in 2017, then we would say the annualized rate of inflation in January was 60%. But the inflation probably won’t keep up at that rate and the 60% is just a way to express what happened in one month.

Suppose you don’t spend exactly like Jaden. Perhaps you really like Cuban black beans and you eat that with rice a disproportionate number of times per day. Aside from certain gastrointestinal issues that we won’t cover here, your own personal inflation rate might be different from the national rate. But us macro people do not care about you – we are more interested in how much the average of all of us is paying for goods and services. So when you read something about the CPI in the USA you need not feel concerned about your own cost of living, as it tells you only about the cost of living of the average person.

The CPI is not the only measure of prices in the USA. So sometimes you will hear about inflation as measured by the Personal Consumption Deflator or the GDP Deflator. Maybe you will read about Producer Prices. The truth is that there are many indicators of inflation but here is the main takeaway. For most of us, the CPI is just fine. And second, while the others are different in various ways they usually tell a similar story about inflation.

One more fun fact. Food and energy prices are notably erratic. They bounce around like a 4-year-old in a bounce house. To get a better reading of all prices, the Labor Department publishes the CPI without food and energy prices. If you are trying to understand the general trend of all prices over time, this CPI Less Food and Energy is your baby. Finally, stocks and bonds and other financial assets are not goods or services -- and therefore the prices of these assets are not included in the usual measures of inflation. 

So why is inflation of so much interest? For one thing it might have relevance to your own situation. For another it might tell you something about the national economy. It might influence your optimism or pessimism about future inflation, jobs, and income.

Here is where it gets a little complicated and even controversial. When inflation is high, the immediate message is that prices are rising at a faster pace. Most of us frown when that happens. But prices do not rise in isolation. Prices are part of a bigger macroeconomic scene. It depends very much on some of those other things as to how a rise in inflation impacts you and me and the nation.

Suppose we are living through a time of great optimism and growth. Jobs are plentiful and wages are rising. In that environment, a rise in the inflation rate doesn’t seem ominous. Okay the price of eggs went up, but I have a great job and my earnings are growing faster than prices. In that case, inflation is just part of a very positive economic situation.

Instead, suppose we are living through a time in which inflation is rising but people are losing jobs and/or wage growth is stagnant. That is the kind of time when inflation really hurts. Such times are not frequent but do happen and are usually the result of business productivity rising at a slower pace than business costs. Some of us geezers remember the 1970s when the price of energy was rising so fast that business costs were crippling many companies. Stagflation is a term coined to describe this kind of inflation.

Inflation can be part of a successful economy or the result of a very negative scenario. Since the national economy is not simple, different experts can look at the economy and come away with different opinions. Today the inflation rate is very low and some policymakers see this as a very negative sign. They want to use policy to bring the rate up. Others believe the macro economy is not so bad and attempts to engineer a higher inflation rate will come back to haunt us. So stay tuned.  

Fed Policy and a Rubber Seesaw

You know what a seesaw is, right? It’s a lot of fun. It’s a long board with a fulcrum at the center. Tuna sits at one end and Peter sits at the other. When Tuna move downward, Peter moves upward. You can do that all day. Or until the board breaks.

Lots of things in economics are like seesaws. The price of JD goes down and demand for JD goes up. The value of the dollar goes down and the Scots buy more JD. The Fed reduces the interest rate and the economy expands. Lots of seesaws out there.

In the past, the Fed believed in a seesaw called the Phillips Curve. This Phillips Curve said that if the unemployment rate went down then inflation would go up. Since inflation and unemployment were so rigidly related, either one could be used to indicate a need for monetary policy. A reduction in the unemployment rate meant inflation was rising and the Fed could back off. That is, the Fed would give less stimulus to the economy.

But that was in the past. Now the Phillips Curve is no longer rigid. It’s like the Phillips Curve has a bend in the middle, and both ends are going down. Think of the Gateway Arch in St Louis. Imagine a seesaw with both ends on the ground. Weird. Tuna and Charlie would sit there and nothing would happen. How sad.

Dr. Yellen is very confused about all this. Inflation and unemployment are both down. The thing that is curious about her reaction to all this is that she ignores the unemployment rate being down as she favors the information she is gleaning from the inflation rate. The unemployment rate is so low many folks are being tempted to return to the labor force. That should be a sign that Fed stimulus is no longer needed. But Dr. Yellen doesn’t want to be guided by this. She would rather focus on the inflation rate’s downward status. If the inflation rate is down then, by gosh, she is going to keep stimulating the economy.

It seems crazy and backward to me. Unemployment is very personal. People are getting jobs. We should like that. But we also know that pushing unemployment too low can bring very undesirable results. Just like a racer who runs the first lap much too fast, she may not have enough gas left to finish well. Inflation is also very personal. Most of us prefer a lower water bill to a higher one. Ask your neighbor. Is she complaining about prices being too low?  I don't think so. So why would the Fed want to continue with a policy of making things more expensive for us? 

Answering that question requires a fresh paragraph. Why does the Fed want to make things more expensive? The answer is that the Fed associates a low or falling inflation rate with dismal expectations and a lack of buying power. So even if everyone had a job, the Fed would still worry that something is amiss in the economy. And Dr. Yellen would keep stimulating.

What could be wrong with that? There are a couple of problems. One I mentioned above. We often associate over-stimulus with bad future events such as recessions. The second reason is that lower inflation rates might be the result of things the Fed simply does not and should not control. Maybe that thing is global competition. Or maybe the low inflation rate is the result of innovation that lowers prices. Clearly the Fed has no business or tools to interfere with either of those things.

Dr. Yellen has her teeth clenched like a dog with a bone. And she is not going to stop clenching until she gets us back to the good old days when inflation was soaring. She might coax output and income growth above 3% for a while. But if we learned anything from the past, an economy that grows too fast too long gives us a recession and higher unemployment. It is quite possible and highly desirable for her to implement a less stimulating policy. She should get to that task immediately and quit using low inflation as an excuse. Demand too low out there? Ask Amazon.com. I don’t think our problem is insufficient demand. 

Fed Gone Wacky?

Bloomberg.com had an article last week with a photo of a smiling Janet Yellen which said that the Fed was elated that the inflation rate was rising in the US. On the same day was an article “The Fed Embraces a More Diverse Future” that had several quotes from Fed officials decrying disparate effects of unemployment on minorities. Minneapolis Fed President Neel Kashkari promised to “spend a day in the life of a struggling black family in order to better understand that experience.” The article concluded  

“While the Fed may have no direct ability to do anything about this relationship, it may be less willing to call an overall unemployment rate of 4.5 to 5 percent full employment if it coincides with a black unemployment rate of 8.5 to 9 percent.”

I wanted to know more about the explicit goals of the Fed. I found the below words at a Federal Reserve website https://www.federalreserve.gov/faqs/money_12848.htm

The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act. In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

Wow. Double Wow. The Fed’s explicit job is to control inflation and employment. Yet today’s Fed officials are happy to see more inflation and are not content when they reach their goal of full employment.

Interesting is how cavalier the Fed is departing from its statutory mission. I can see it now. Hey coach I think I would be more popular if I played guard on our football team. But son, you are a quarterback. Come on coach, the linemen are cool guys and I always wanted to hang with the cool guys.

The Fed has no mission and has no ability to affect the composition of unemployment. If they drive the unemployment rate below the usual definition of full employment – they can provide some jobs for those at the lower end of the labor pool. But history shows that such jobs do not last very long. Driving unemployment so low will cause the economy to run fast enough to absorb more workers. But like any engine that runs faster than normal for a while – it will generate frictions that eventually bring it back to normal – if not requiring a new engine! History suggests also that the aftermath of such reckless driving is often the dreaded scourge stagflation wherein both inflation and unemployment rise together. At some point the Fed then has to tighten and cause a recession and even more unemployment. Thus gains are not only temporary but they end up worsening the entire economy.

As for the seemingly perverse joy over a September rise in the inflation rate, this just underscores my point. Yellen has recently been quoted as saying it would be okay for the economy to run hot for a while. I like my coffee hot but she is delusional if she thinks a hot economy is a good thing. Higher inflation and a hot economy won't accomplish anything except to raise and then dash the expectations and lives of those least able to deal with such changes. 

Unfortunately our current Fed has fallen for the liberal line that one should focus on the short-run. Despite relying on nothing more than dreams and drugs, our Fed wants to make people feel happy that it is doing something. But like many do-gooders, the Fed has neither the tools nor the mission. Just because Congress is broken it does not mean the Fed can pull a rabbit out of a hat. Unequal incomes may be a problem but like the QB who wants to be an offensive lineman, the Fed is neither qualified nor licensed to solve this problem. Mrs Yellen -- please just stick to your job description.  

2% Inflation -- A Fool's Quest

I wrote a piece on January 19^th about the Fed’s 2% inflation goal mostly saying that the 2% was a ruse – a way to take your eye off the ball. The Fed wants the unemployment rate lower and the economy stronger and the low recent inflation gives them the excuse to keep their pedal to the metal.

But there is more to the story. So let’s beat on the inflation goal again but in a different way. It seems clear why the Fed might want to adjust policy so as to reduce the unemployment rate. Higher unemployment hurts people. Lower unemployment is a sign of a healthier economy. I am not saying that the Fed is good at lowering the unemployment rate, but it seems to make sense that lower unemployment might be a desirable end.

During much of my lifetime, the Fed’s main goal was to reduce pesky inflation. That seemed reasonable too. Inflation is annoying. Ask folks who lived in any country ravaged by 100% inflation. Inflation hurts. Even when inflation hits 5-10% per year few of us like that. But the Fed tossed all that out lately. Their goal is to raise inflation. What? Why would they want to do that?

The answer has nothing to do with inflation or prices. The answer is that low prices might be an indicator of flagging or deficient national demand for goods and services. Influencing sagging spending makes sense but if you are concerned about low aggregate demand then why doesn’t the Fed come clean and say it is trying to raise AD? The answer is that AD is like love. Love is not directly measurable. Does she love me or does she not? We are always guessing about such things. If you want to know if someone loves you then you look at behavior. Apparently the Fed thinks it can look at measured prices to know what is happening to AD.

The problem with looking at inflation to gauge AD is that it simply is not very good for that purpose. For one thing, inflation reflects aggregate supply (AS) as well as AD.  When inflation falls because of increases in AS – then the Fed should not be reacting to that. So if the Fed has no direct measures of love or AD or AS, then inflation can be a dangerous and misleading indicator. When inflation falls is it because AD went down or because AS went up?  It is hard to know and reflexively presuming AD and inflation are the same thing has frequently led to grave policy errors and unnecessary economic suffering.

A second important problem with using inflation as a measure of AD is that inflation is like Steve Martin – wild and crazy. Inflation measures jump around like a kid on a red ant hill. Below I use some inflation data to make my point. The Fed might as well use lighting strikes to measure AD…it is a fool’s game to use inflation numbers.

My measures of inflation today are called implicit price deflators for GDP.  They are published by the Bureau of Economic Analysis and found at bea.gov with the various GDP statistics. Notice in the detailed table below there are inflation numbers for 2014 and 2015 for every component of GDP. This is a very comprehensive measure. It is broader than the consumer price index since it includes inflation rates of prices for things like plant, equipment, and exports. The closest thing to the CPI in this group is the deflator for personal consumption expenditures. 

I said above that inflation numbers are wild and crazy and could not possibly be good proxies for what is happening to AD or anything else. The overall index for inflation (for GDP) was 1.6% in 2014 and then 1.0% in 2015. The Fed would say that the national inflation rate fell and might be a problem if AD fell in 2015 and worsens in 2016. So far so good. But let’s look inside the wrapping of that sausage.

While the prices of consumer goods were falling by 2.9% in 2015 notice that the prices of consumer services rose by 1.9% after increasing by 2.3% in the year before. Note that the inflation of consumer services averaged those two years around 2%. Thus consumer services prices are at the Fed’s spoken limit. By the way, consumer services were approximately 65% of all consumer spending and 45% of GDP. In contrast, wild and crazy durable goods are only 13% of consumer spending and 9 % of GDP.  The durability of future inflation rates are much more associated with the heavyweight consumer services and much less influenced by wildly gyrating prices of consumer durable goods.

The GDP component we call investment includes purchases of capital goods – plant, equipment, software, buildings, and more. While consumers buy residential investment, the rest of these items are generally purchased by businesses. Notice the behavior of prices in this category. While the prices of the nonresidential portion of investment goods barely budged in 2015 (0.2%), prices of newly produced residences rose by 2% after rising by 6% the year before. Finally look at the behavior of both import and export goods.  Prices fell in those categories by 7-8% in 2015 after being pretty flat in 2014.

When you read the first line of the table and see that the US inflation rate fell to 1% in 2015 one might get the impression that the prices of most or all goods and services followed in lock step and somehow national AD must be on the decline. But this could be very misleading since the average masks a lot of different and conflicting changes – each one having a very different implication for AD or AS. Clearly spending on the biggest part of GDP, consumer services, was strong enough to put inflation of consumer prices at the Fed’s goal value. If you add prices of new residences, you get the same result – healthy enough spending to put inflation at 2%.

So what causes the impression that inflation is falling? Clearly sectoral issues that may or may not be AD in origin make the results very muddy. For example, prices of consumer nondurable goods retreated because of gasoline prices. Lower gasoline prices, however, should give consumers more money to spend on other items. Prices of imports and exports figured into much lower prices of those categories. Again, how much do these international changes reflect ongoing AD issues that our within our sphere of influence?

A closer look at inflation numbers suggests a mixture of temporary changes in highly volatile sectors and a mixture of AD and AS impacts. They paint a very unclear picture of how national AD is changing and a poor clue as to what will happen to inflation and AD in the future. The Fed should stop talking about inflation and be more honest about its true goal. The Fed has become Supergirl of modern times. Even the tiniest worry about unemployment or economic weakness sends the Fed into action. This was never the intention of the framers of the Federal Reserve Act and ignores all of the unintended negative impacts and imbalances that such policies have shown time and again.

Table. Inflation as measured by changes in

implicit price deflators of GDP

                                     2014  2015

Gross domestic product	1.6	1.0
Personal consumption	1.4	0.3
Goods	-0.4	-2.9
Durable goods	-2.3	-2.1
Nondurable goods	0.6	-3.3
Services	2.3	1.9
Investment	1.8	0.6
Fixed investment	1.9	0.6
Nonresidential	1.0	0.2
Structures	1.5	-0.5
Equipment	0.7	0.7
IP products	0.9	0.0
Residential	6.1	2.0
Net exports	na	na
Exports	0.1	-4.9
Goods	-0.7	-6.8
Services	1.9	-0.6
Imports	-0.2	-7.7
Goods	-0.5	-8.9
Services	1.2	-1.7
Government	1.8	0.2
Federal	1.6	0.7
National defense	1.4	0.2
Nondefense	2.0	1.4
State and local	1.9	0.0

2% Inflation and the Fed

The Fed seems to have a thing about 2% milk. Or was that 2% inflation? It has become a passion with them. It’s like your mom when you were a kid. Honey, if you are good we will take you to Legoland. What is good Mom? To start with clean up your room. And then you should get straight Bs. Straight Bs? Why do I need straight Bs to be good – good enough to go to Legoland?

Mom knew that I would never get straight Bs. I could hardly sit in my school desk for five minutes let alone concentrate long enough to get a B on anything. The Fed has been singing this 2% inflation song for quite a while – and all during that time the chance of inflation reaching 2% was about the same as my getting straight Bs.

Why is the Fed so disingenuous? Mostly to take our collective eye off the ball. There used to be a time when the proper role of the Fed was to provide just the right amount of liquidity to the economy and restrain inflation. But then the Keynesians messed things up and suggested that since the government is totally inept, the only organization besides Donald Trump left to control the economy is the Fed. So instead of humbly trying to  dampen inflation and inflation expectations the Fed has turned into this multi-headed hydra doing everything from dunking basketballs to fine tuning the unemployment rate.

Janet has no troubling dunking so she and her fine fellows at the Fed (notice all the Fs) have spent the last 8 years or so telling us bedtime stories about monetary policy and the unemployment rate. Janet will not rest until every last legal and illegal fast-food server has a full time job with rapidly growing wages. She is still a long way from reaching that goal so she is even more dedicated. But here’s the rub. Aged economists like myself keep reminding her that at some point after she has poured enough money onto the smoldering economy she will have created enough economic and financial imbalances to sink a manatee.

Janet wants to please even old guys like me so she gives what we might call “lip service” to the idea of inflation. Janet wants unemployment much lower (and wages much higher) and will say just about anything so she can say she slayed the employment dragon. One thing she can say is – look dudes. I poured enough money on the economy to drown China and look – no inflation. Well – there is some inflation so she had to come up with a number for the perfect amount of inflation and that number is 2%. She keeps pointing out that inflation is less than 2% and she acts as if that is a bad thing. Is it a bad thing when your money buys more? Instead of saying she wants the unemployment rate lower – she chides us with this silly statement that inflation is less than 2% and that is a bad thing! Worse – she says – we must keep stimulating the economy until we can get inflation up to 2%. 

Up to 2%!!! Am I yelling? I spent my whole 169 year career thinking the Fed is supposed to REDUCE inflation. Where did we get this raise inflation crap??? It is just like those straight Bs. Mom didn’t want to take me to Legoland. Janet does not want to raise inflation to 2%. What Janet really wants is a gold star for employment achievement.

You say – but Larry – the Fed just raised the interest rate. Are you never happy? Did you never get to Legoland? Yes, I did get to Legoland and it was wonderful. As the Fed announced its miniscule increase in the interest rate it spent more words reassuring us that the future increases will be so gradual that no one will even notice. But even that tiny little interest rate increase isn't guaranteed. If ANYTHING comes up this year that has even the tiniest possibility of slowing growth in the US economy you can be sure that the Fed will end their attempt to restore a bit of normalcy to monetary and financial conditions.

2% inflation is a gimmick and it means nothing. What matters is the Fed’s progressive agenda and that it is riveted on the unemployment rate and economic growth. Mark my words. If the inflation rate rises close to or above 2% while the employment situation is not sufficiently solved – the Fed will explain why 2% was never a rigid target. The Fed will then explain why 3% makes more sense. Hey guys, is 4% really so bad? 

Why am I so mean about the Fed? The answer is that they don't read the handwriting on the wall. First, remaining issues with employment have nothing to do with monetary policy and everything to do with long-term structural issues. Loose money and low interest rates are doing little for growth and everything to increase imbalances. Second, we already see the worrisome bubbles developing that arise from near-zero interest rates. Third, if inflation does begin to rise despite little progress on employment, the Fed will likely ignore the inflation and will end up creating a very unstable stagflationary environment. Those of you who experienced all that in the 1970s know why that is not a desirable end. 

The Fed should stop this charade about wanting a higher inflation rate and just tell the truth. They are not going to stop this abnormal monetary policy until every last one of us has a full time job and wages are growing faster than kudzu. Domestic and global imbalances be damned. 

The Fed, Inflation, and Recessions

In my post last week I stated that recessions were often caused by monetary policy actions. Some people think it is bazaar if not evil to say such a thing. Policy is formed to create good outcomes – not recessions. But policymakers are just like you and me – prone to error and especially so when we think we are doing something for the greater good.

Since I sometimes write things based on what I think I know, I decided to bring up some data and see if there is any truth to what I think I know about inflation and recessions. But let’s first review the simple theory since it is relevant to current monetary policy.

     Monetary policymakers worry the economy is fragile so they keep interest rates low by letting the money supply expand faster than my belt at a July 4^th BBQ.

      In so doing they risk overheating the economy

     When the economy expands too quickly this leads to higher inflation

     Upon seeing higher inflation, the Fed restricts money, interest rates rise, aggregate demand contracts, and a recession ensues.

     Cinderella is then run over by her coach. Yes she was a little tipsy.

Looking at graphs never proves a theory but I am so old that I have forgotten how to run proper scientific experiments and besides, many of you are cynical enough to believe I faked the results anyway.  You can check or reproduce my results by going to the FRED data service at https://research.stlouisfed.org/fred2/  . Then choose the Consumer Price Index for All Urban Consumers: All Items. Then choose annual rates of change. That is what I call “inflation’.

I begin this story by looking at seven US recessions from 1970 to 2008. That means we are looking at almost 40 years of US history. If you want to go back farther that is okay with me but I figured that is enough years for our purposes here. These seven recessions are shown on the graph below as vertical shaded areas.

Inflation went from:

           less than 2.5% to more than 5% right before the 1970 recession started

           a little more than 2.5% to more 10% before the 1974 recession

           just over 5% to around 13% before the 1980 and 1982 recessions

           under 2.5% to over 5% before the 1992 recession

           about 2% to over 3% before the 2002 recession

           about 2% to about 4% before the 2008 recession

Every one of these seven recessions was preceded by a substantial and worrisome increase in the inflation rate.

That’s pretty interesting. Do I hear clapping in the background? But some of you sharp cookies (since when is a cookie sharp?) are saying stuff like the following. This proves nothing since Larry is focused on just two variables. If money is part of the story, then clearly I need to show the following – inflation was worrisome enough to elicit a Fed tightening of policy and that tightening caused the economy to contract. And the coup de gras (Charlie, coup de gras is not a race car) is that I need to show that nothing else was a major contributing factor to each of these recessions. For example, some of you smarty-pants will point out that the dot-com bust was a major factor causing the 2002 recession.

To the above I say raspberries (why is there a P in raspberries?). I could add more data but this is a family blog and I don’t want to pollute the environment.  I challenge you to do some simple search research with your favorite search engine using words like inflation, monetary policy, recession, 1980.  You will find it difficult to dismiss the strong possibility that too much money caused inflation and too much inflation caused tight money and ensuing economic contractions.

Which leads me to the following question: Does the future or at least the next few years have to imitate the last 40 years?

     Maybe that graph and all the discussion above is irrelevant for beyond 2015. 

     Maybe all that money injected recently will not ever cause higher inflation.

     Even if inflation does begin to rise, maybe the Fed won’t tighten vigorously

     Even if the Fed worries about rising inflation and tightens, maybe it won’t cause a recession

Since this blog is about you as much as me, I won’t answer those questions. But I am wondering what you think about them. Are we in a new world in which inflation is not a problem? Will that new world imply that the rules of money have been revoked? Will the Fed escape a period of historical monetary increases without causing a dent in the future economy? Does Janet Yellen know how to cha cha cha? 

Lesson 5 The FED and Monetary Policy Gone Bad

In 2015 we in the US regard the Fed as the only macro policy game in town.   In macro we teach about macro problems and macro policies. Because Congress is largely dysfunctional there is little hope that they could pass a bill which adequately addresses macro problems. What is often referred to as fiscal policy, or use of government spending and taxes to address the economy, is now mainly neutered. That mostly leaves The Fed as the only policy game in town. 

So there is much attention focused on Fed policy. In this summer of 2015 we are told that the Fed will soon change its policy. But there is much uncertainty about when and by how much the policy will change. So the financial markets are a little crazy. And the economy bobs up and down. Do we really have to experience all this madness?

I think not. The problem is that the Fed is trying to do something it is ill-suited for. It has taken about 60 years to figure this out but I think it is getting plainer all the time. It is like the 40 year old man who after a brief bout of unemployment gets a new job. Yet his mother isn’t satisfied. Honey – did you brush your teeth before you went to work? Were you nice to your new boss? Did you polish your brown shoes? This man has things under control and he doesn’t need his mother giving him bad advice. Mom – stop it! Fed – stop it!

This Fed is like this doting mother. The economy might have needed some Fed support in 2008. But if you look at your calendar, you will note that was seven years ago. The recession ended in 2009 and the US economy has been expanding ever since. I know of no theory of macroeconomics that says that expansionary policy must continue until everyone on the planet believes there is a 100% chance the economy might not regress.

Think about the theory of macro policy. First, John M. Keynes did not believe monetary policy should be used to stimulate the economy.  He likened it to pushing on a string. Second, he did believe the government could and should stimulate the economy – using what he likened to a priming operation. In a priming operation the government spends a little more and taxes a little less to get a little bit of spending going. Presumably this injection of spending will increase our incomes and our confidence and get things moving. Like the ball in a pin-ball machine, the ball doesn’t exit before it bangs against numerous cushions that indicate increases in your score. The injection of a little bit of stimulus gets us all spending before the injection ball exits the economy.

Keynes was writing in the 1940s and much has happened to this humble theory in the last 70+ years. Keynes’ followers (Keynesians) decided to quantify all this and before we knew it we had an elegantly expressed general theory in which the government and the FED could alter monetary and fiscal policies to keep the unemployment rate always at full employment with a corresponding GDP Gap equal to zero. Gone was the priming issue. Gone was the skeptical attitude about monetary policy. And of course gone were the days of conservative government budgeting and near-zero inflation. 

Consider where we live now – in a world where

            it is expected that the Fed if not the government will stimulate until we reach full employment;

            we have annual budget deficits and almost no surpluses and a national debt that is soaring;

            inflation has followed EVERY significant policy stimulation; and

            these inflation bouts were followed by policy reversals that led to recessions or very slow growth periods.

Anyone with an objective attitude about macro policy as practiced in the US since the end of World War II could not be very happy with these results. We clearly have a frying pan- fire-frying pan experience. What went wrong? It seems pretty straight forward. Macro is a legitimate social science. If macro indicators are showing a significant recession or slowdown, then policy variables can be altered so as to increase aggregate demand which in turn stimulates other spending until the macro indicators can be drawn with happy faces around them.

That sounds pretty easy. But the truth is much different. Hey mom, I have a temperature. Okay honey. Stick your head in the refrigerator and you should be fine in a few minutes. That sounds pretty stupid. But our Keynesian approach to macro problems and policy is the same. Follow me on this. I believe in macro. I believe that when real GDP declines this is a problem needing study and remediation. Okay so far? But what I do not believe is that EVERY TIME real GDP or other macro indicators fail to achieve better values, that we have a generalized macro problem requiring monetary and/or fiscal policy.

How is it possible that a macro slowdown is not caused by macro factors? Simple. We have a macro construct called aggregate demand. And Jim and Toni have five kids. Peter slugs Diane and she cries. Then the other three kids cry. Uncle Charlie comes in and sees five unhappy kids and concludes that Jim and Toni have been abusing their children. He sees virtually the whole family in disarray. The problem must have been caused by the parents, Jim and Toni. That’s what our brilliant macro economists do when they see aggregate demand falling. If AD is going down, then macro policy needs to bring it back up. Presto!

But in my family example above, the problem is that Peter is a mean boy and slugs people. There is no family problem. There is a Peter problem. The solution should be to fix Peter (please no Jenner jokes) . Fixing the whole family is misplaced. It lets Peter off easy. It is inefficient and won’t lead to a solution for a happier family.

And so it is with a fixation on aggregate demand and the national unemployment rate. There may be times when all of aggregate demand is declining. And in those times a general AD approach might seem reasonable. But in many or most cases, the problem showing up in AD is really a specific problem stemming from housing, or autos, or Japan, or other parts of AD or AS. Yes, sometimes AD is falling because of aggregate supply problems. In these cases, AD policy is wrong and inefficient at best. The right policies are those that address the real problems be they housing or autos or Japan or AS.

Today our Fed continues a zero interest rate policy* that intends to stimulate aggregate demand. The leaders explain with great pride that they will not relent in this generous policy so long as we have even the tiniest negative GDP Gap. Yet the economy jumps up and down and financial markets have fits because there are plenty of problems with the economy that do not get addressed because the Fed is so focused on AD – and AD hasn’t been the problem for years. Should the economy continue to slowly heal itself despite the FED, we can be sure that we will soon be wondering why inflation got so bad so fast – and wondering why the FED's abrupt policy reversal is throwing us into the next recession. 

* One more point. A zero interest rate policy might seem innocent enough. But note that in order for the Fed to keep interest rates near zero, it takes actions. To keep interest rates near zero in the last two years meant increasing the money supply. This is done by increasing something called the monetary base. It grew by 39% from Q1 2013 to Q1 2015. The result was that the narrow version of money, M1, grew by 20% during that time period,. The wider version, M2, grew by 13%. Money is exploding despite the fact that we have a growing economy. This is risky business. 

Lesson 4 Potential Output, the GDP Gap, and the Intelligence Gap

This post is really about inflation but I didn’t want to mention inflation in the title so as to not scare you. Actually it is really about inflation policy so let’s start there before we get into excruciating technical definitions, mathematical equations, and kimchi recipes.

Some of you are old enough to remember inflation. Inflation means the cost of cherished goods and services is rising. One day you went to Whole Foods for one small bag of groceries and it cost you $1,000. Today you go and that same bag of non-pesticidal fruits and nuts costs you $1,100. You would say, yikes Helen, those dirty scum-#$%^&*s at Whole Foods are ripping us off and making it impossible to send our genius Golden Retriever Bogey to Harvard. Or you might simply say that inflation was 10%.

Since the great recession in 2008 the inflation rate has been very low in the USA. While the inflation rate was generally rising between 2001 and 2008 it has been falling ever since. It did rise briefly to nearly 4% during 2011, but it reversed course and inflation has been falling ever since.

So there are great minds who basically say “Inflation who?” implying that inflation is like your brother-in-law after the divorce. You ain’t gonna have to see him again! Very smart economists who teach at wonderful places like San Diego State and Harvard would swear on a stack of Paul Krugman articles that the Fed can pump in money and the government can spend its way to oblivion and back – and still not awaken a comatose inflation dragon. I know. I am mixing metaphors. Or was that a simile?

I know you have been waiting patiently for some really boring definitions but I had to get you ready. If you are like a lot of my friends, you haven’t read an economics book since Prof Schaffer’s class in 1964. Potential Output and the GDP Gap exist for one and only one reason – to help us predict future inflation. The above suggests that inflation is hiding at the moment. But this blog is all about how and why inflation might awaken from its long slumber and possibly be in a very ugly mood.

Remember GDP? GDP is a nation’s output. It is measured fact. It is the size of that pile of goods and services that got produced this year. It could be really big this year because Zeus was happy or it might be small because Kim Kardashian forgot to go shopping. Either way, GDP is what got produced.

Potential GDP is part of a fairy tale or what economists like to proudly call a counterfactual. Potential GDP is what GDP could have been. It’s like your kid’s potential. Okay, so he can’t actually hit the broadside of a barn with a large pumpkin but you are pretty sure that if he practices a lot he will soon be starting on the mound for the Royals. Potential GDP is how much output would have been produced this year if the economy’s resources were fully utilized. It is possible that actual GDP could equal its potential in a given year – but honestly, when is the last time your kid started for the Royals?

The GDP Gap is the difference between Actual GDP and  Potential GDP. Most of the time, the current GDP is well below its potential because most of the time resources are not being fully utilized. Thus, most of the time the GDP GAP is negative.

The main productive resource that tends to lag is employment. Those dern workers just love to sit around and watch Oprah every day instead of going to work and producing huge mounds of widgets and zidgets. Or those dad-gummed firms love to fire workers who then sit around and watch Oprah. In either case, if there are unemployed workers looking for work, this excess shows up as a negative GDP gap.

Here is the point – an excess of workers seeking employment (or improved employment) and a corresponding negative GDP Gap represent a weak economy with weak spending It is one that grows slowly and one that is not capable of producing inflation. As a result the US Fed is more concerned about the weak economy than it is about rising inflation. That relative concern retards their movement to a more normal policy. It puts off the day when the Fed removes a lot of money and stimulus from the economy. When employment improves and the GDP GAP turns toward positive territory, then the Fed will turn its sights towards mediating inflation. The big question now is when will that day come? When will policy return to normal? The GDP Gap is heading towards positive so we know a policy change will come.

The intelligence gap has to do with the Fed’s reluctance to move to a saner policy. Why do I say saner? The economy is exhibiting a return to stronger economic growth. Inflation is not one of those things that require bugles and a formal announcement heralding its arrival.  I know that GDP turned sour in the first quarter of 2015 but everyone including your barber’s Doberman knows about the temporary factors like a massive dock strike and storms attributed to global warming caused economic problems in Q1 that will not be repeated in Q2.

Now we have economists giving the Fed even more ammunition to continue a risky policy. A recent report (Changing Labor Force Composition and the Natural Rate of Unemployment, by Daniel Asronson, Chicago Fed Letter, #338) explains that labor will not be fully employed until the unemployment rate reaches between 4.5% and 4.9%. That means we will have a negative GDP Gap until the unemployment rate reaches about 4.5%. That means the Fed has a numerical excuse to not worry about inflation and to not engage in a more conservative policy for quite a while.  Meanwhile the economy gains momentum and some measures of inflation (percentage change in the CPI less food and energy) are closing in on the 2% goal value. Once at the goal value notice that it won’t take long to exceed it. And then the Fed will be in a really difficult position. Do they really want to have to aim all their guns on inflation knowing that a major abrupt change in policy will greatly weaken spending in the economy.

A quicker return to a gradual approach that started yesterday is what was needed. Waiting until tomorrow promises going from the frying pan to the fire. 

Monetary Fables and Sand Traps

It is said so many times now it is almost a mantra – Then Fed engineered a recovery for Wall Street, leaving Main Street and most of us to suffer or at least languish. The intuition is easy. Think of Ms. Yellen in a helicopter spewing hundred dollar bills over banks that collect them in giant bins and then hide them in big vaults away from public view. What money does leak out of the banks goes to purchase bonds and stocks and sustains a financial bubble or at least a rally. Fed behavior also keeps interest rates limbo low and cause reallocations of portfolios away from money and into more risky bonds and stocks with higher promised returns. Firms are not allowed to borrow and expand and therefore employment does not increase and both consumer and business spending remain in the doldrums.

I would be surprised if this story has not already made its way into Dr. Seuss or other children’s books.   It has appealing though contradictory themes. The big bad Fed is a lackey of the right wing helping to keep the upper 1% as rich as possible while regular folks suffer. Alternatively the Fed is a willing compatriot of the liberal left, but alas needs to do even more to complete the task. The Fed pumps money into the economy willy nilly praying each evening to Paul Krugman that money will work wonders for Main Street. Surely if the Fed continues on this course and pumps in ENOUGH money, the economy will be saved. Imagine Paul Krugman in tights with a large S on his chest.

Neither of these stories is correct. 

Let’s take the first one. The first one is based on the idea that when the Fed injects money into the system it somehow prefers the filthy lucre to end up in risky financial markets instead of supporting loans that expand the economy.  This one is pretty silly. I don’t know of one money and banking book that suggests any reasons why the Fed would want the rich to get richer at the expense of the rest of us. Historically it is hard to find times when the intention of a loose monetary policy was to avoid real loans and pump up stock markets.

As for the second story, it is true that there is a lot of hope and faith when it comes to money’s magical impacts on employment and output. But this current episode goes beyond hope and even Paul Krugman seems to have lost his tights. Historical amounts of money have been pumped into the US economy and rates have been kept at zero levels for a long time. Yet, the economy stalls. John M Keynes, the great one, recognized the limits of money when he cleverly invented the so-called liquidity trap. Modern Keynesians agreed a long time ago that once a country enters the trap it is like a monetary Bermuda Triangle in which everything gets sucked onto a giant hole never to be seen again. Money can approach savior status but not when expectations are tender. It makes no sense to keep pouring money into this economy and it makes no sense for money to pull us out of slow growth. This is what Keynes and his band of merry Keynesians said to Maid Marian and Friar Tuck.

Most textbooks and Fed statements suggest some very clear avenues about money. The money mechanism is simple but it is full of traps. Here is the usual story.

·        The Fed sends a check to a bondholder in exchange for his bond. Bond interest rates fall.

·        The check is deposited in his bank.

·        Banks have more money and do not need to borrow to raise funds and the Federal Funds Rate (FFR) falls.

·        Since the FFR is a cost of funds, this causes other interest rates to fall.  

·        Households and firms hop on the first bus to their banks to borrow money.

·        With these low-priced loans consumers buy durable goods and firms buy capital goods.

·        All this spending causes firms to hire more workers and expand output.

·        Christmas comes early.

If the above sounds like a fairy tale to you it is because you have learned about the traps – all the things that could go wrong so that none of the above actually happens on your planet. So here is a brief list of these traps:

·        Liquidity Trap: Bondholders are more than happy to sell their bonds to the Fed so bond returns do not fall much.

·        Deposit Trap: Worried about banks, investors do not deposit checks in the banks. Money might leak out directly to shadow banks or financial investments.

·        Loan Trap: either banks do not trust borrowers or borrowers are too indebted to even ask, so loans do not increase.

·        Spending Trap: No loans, no spending.

·        Employment Trap: even if households and firms do begin to want more goods and services, firms may be pessimistic about the future and not want to make permanent increases in employment or output.

·        Uncertainty Trap: so long as policymakers keep trying to make things better – and they don’t get better – firms and households become even more uncertain and conservative in their decisions.

·        Left tackle Trap: when the left tackle feigns a missed block and the defender comes rushing in for glory and finds that the left guard is there to smash him to the ground.

My first point is that the Fed need not be a lackey of the left or the right if it somehow misread a golf course full of traps. Why do so many golfers end up in sand traps? Because they know they need to take risks to come from behind. They need a low score and at the moment they are way behind the leaders. With unemployment at 10% and a mandate to reduce it, the Fed chose a risky path that ended up with us in a lot of traps. Because the recession was not your run-of-the-mill downturn, the Fed did not anticipate a lot of the traps. Once in the traps we lose. You would think that recognition of such mistakes would be influential but this risky behavior carries on even today. The Fed remains unwilling to reverse its risky policy.

Which brings us to my last point before I sit down to a large bowl of JD. Yes, I know I forgot to mention JD in my last post and I got several angry letters from JD Distilleries worldwide. My last point is all this concern on the part of the Fed that without their continued hose full of money pouring on the economy, interest rates are going to rise to the stratosphere and the economy will come crumbling down. What gall. Does the Fed really have all that control over the economy? No and for several reasons.

First, all those traps listed above suggest the Fed often has little control. Second, there are huge money and financial markets out there that determine asset prices and rates in the USA and globally. If participants in those markets think rates are going to rise in the future, then they will make trades that push the rates up today. There is little to nothing the Fed can do to offset a major change in market psychology. Think of the little Dutch kid with his finger in the dyke. His T-shirt reads "I am the Fed."  In Dutch, of course. 

Finally why would the psychology change to make participants more certain that rates are going to rise? For one thing, the US economy is gathering steam. Among the many positive indicators was the recent announcement that labor costs are rising. All that money outstanding will eventually have to go somewhere. Some of the above traps will disappear – banks will make more loans, firms will replace decaying equipment, and households will buy more cars and JD. Firms will hire more workers. Prices might be under control, but there is no way for them to go except up. The best guess is for higher inflation and that too will drive up interest rates. This is not magic. This is what usually happens during an economic expansion. Rates return to normal with or without the Fed's love or encouragement. 

The Fed knows rates are going to rise and it can’t do a thing about it. It should give up this silly game of hubris and just back away. Pull that money out before it causes a fire! The longer the Fed waits, the more the negative backwash. Get on with it. The markets are ready for a return to normalcy. And I am ready for that JD.