Inflation – What Me Worry?
Raymond James
By Scott J. Brown
May 16, 2011
Despite rampant hysterics about “runaway inflation” in recent months, core inflation has remained at a moderate level, inflation expectations remain well-anchored, and there is little inflation pressure coming through the labor market. Is it time to declare victory? Not just yet, but the inflation outlook still does not appear to be particularly troublesome.
The CPI ex-food & energy rose at a 2.1% annual rate in the first four months of 2011. That’s just a little over the Fed’s implicit goal (of 1.7% to 2.0%). Short-term inflation readings tend to be choppy (which is one reason to focus on the year-over-year trend), but the increase in core inflation is not unwelcome. It was trending too low for the Fed’s comfort last year. Remember, real (that is, inflation-adjusted) interest rates are what matters. Low inflation means (all else equal) higher real interest rates. Higher inflation reduces real interest rates, which is stimulative for the overall economy.
Note that, yes, the Federal Reserve does consider overall inflation, not just the core. Food and energy prices do count, but the increases in food and energy prices in recent months do not appear to be part of a broad inflationary trend. Rather, they are the result of short-term supply and demand effects. Most economists, including those at the Fed, have anticipated that oil and gasoline prices would stabilize or retreat. The recent drop in gasoline futures suggest that the retail prices should begin to fall (at this point suggesting about a 25-cent decline in the next few weeks, but that outlook can change quickly).
What about commodity prices? Aren’t they signaling higher inflation? There have been three factors behind the run-up in commodity prices. One is the global growth story. Stronger demand from China, India, Latin America, and so on, will put some upward pressure on commodity prices (in addition, there have been supply concerns in oil relative to developments in the Middle East and North Africa). The second major factor has been monetary policy. Commodity prices tend to be high when interest rates are low. The third factor is the speculative element. The supply and demand fundamentals get you only so far. Commodity prices (and prices in most other markets for that matter) depend on what investors think someone else will be willing to pay. Over the long term, the fundamentals should win out, but the speculative aspects can dominate for long periods. The commodity fundamentals have not shifted dramatically in the last few weeks, suggesting that the recent correction and intraday volatility are due to a revaluation of the speculative element. Where that ends is anybody’s guess.
For the Fed, the key concern is whether higher gasoline prices will lead to second-round inflation effects, higher wage gains, or a rise in inflation expectations. So far, the ability to pass along higher fuel prices appears limited. Some will get at least partly passed through. However, higher gasoline prices have a dampening effect on real consumer spending, as retailers will have to compete for the consumers’ dollar. There is no sign that wages are rising significantly. That’s the big difference between now and the 1970s (when OPEC oil price increases quickly led to inflation becoming embedded in the labor market). Finally, there’s no sign that inflation expectations are getting out of hand. The Philadelphia Fed’s latest quarterly Survey of Professional Forecasters has the CPI rising 2.1% over the next four quarters (3Q11 to 2Q12) and a 10-year inflation outlook of 2.5%. The Cleveland Fed’s latest estimate of 10-year expected inflation, based on surveys and market-based information, is 1.86%. Inflation expectations remain well-anchored.
Why all the inflation hysteria then? People often worry about things that they shouldn’t worry about, and don’t worry about things that they should worry about. We’ll continue this theme next week, when we discuss the federal budget deficit.
(c) Raymond James
