Tuesday, February 8, 2011

When is Inflation a Problem?

Financial FAQs

Does it seem like the price of everything is rising these days—particularly food and gas prices? It really depends on who you talk to, and this is reviving the age-old debate between deficit hawks and doves. The old saw that inflation is first and foremost a monetary phenomenon was coined in the 1950s. Thank you, Milton Friedman, for the most simplistic formula ever to come out of academia.

Of course, he meant that inflation depended on the amount of money in circulation vs. the amount of goods available to purchase—the most basic Law of Supply and Demand. Wars tend to be more inflationary, because employment is high while much of production is tied up in making guns instead of butter. During recessions such as we just experienced, on the other hand, there is a surplus of goods and deficit of money in circulation. Fewer people are working, in other words, so they can’t buy as much.

And right now we are in a disinflationary trend—which means prices are falling, but there is still some inflation—vs. outright deflation such as Japan is still experiencing, where wages and prices are actually shrinking.

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What is making the deficit hawks nervous is that headline inflation—i.e., overall inflation including food and energy prices—has been steadily rising since July, 2010. This is using the Personal Consumption Expenditure price index, which is the best overall measure of domestic prices. But the core rate without food and energy prices hasn’t budged. Why? Because consumers aren’t buying enough of the products and services affected by food and energy prices—such as motor vehicles (though demand for vehicles is rising).

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Therefore, the overall inflation trend is still downward. The core rate came in unchanged after edging up 0.1 percent in November. On a year-ago basis, headline PCE prices are up 1.2 percent, compared to 1.1 percent in November. Core inflation eased to 0.7 percent year-on-year versus 0.8 percent in November.

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What is happening to interest rates? Longer term rates are rising in tandem with the rising loan demand from consumers and businesses, as evidenced by the Treasury Yield Curve. Employment is picking up, in other words. Approximately 1 million jobs were created last year, of the more than 8 million jobs lost during the recession, and the unemployment rate has dropped to 9 percent from its 9.8 percent high.  But short term rates that control the Prime Rate and mortgage ARM indexes are still close to zero because of the Fed’s QE2 program of buying back Treasury Bonds.

So inflation is still way below the Fed’s ‘implicit’ target range of 1.5 to 2 percent. That is why the Fed wants to continue with QE2. Right now, the emphasis has to be on creating jobs, and keeping the inflation rate from falling further. For, falling prices mean lower profits for employers, which mean shedding jobs rather than adding them.

Then why are food and energy prices rising, if inflation is still low? Firstly, food prices have been rising because of major droughts in Russia, China and parts of Africa; major bread baskets of the world. And energy prices are rising because of rising energy us from the developing countries—including major population centers like China, India, and Brazil.

This means those prices are totally out of Federal Reserve control. In fact, some energy inflation is good because it speeds up incentives to convert to alternative fuels, which means cleaner energy use and less dependence on Middle East oil.

What about our soaring budget deficit? That is the other reason the Fed is pushing down interest rates. Right now, the costs of borrowing are at record lows. Something like just 10 percent of the federal budget goes to interest payments. So raising interest rates would only increase the budget deficit.

There is more good news on the hiring front. The Labor Department’s latest Job Openings and Labor Turnover Survey (JOLTS) said the number of job openings in December was 3.1 million (yellow line on graph), which was little changed from 3.2 million in November. Since the most recent series trough in July 2009, the level of job openings has risen by 0.7 million, or 31 percent. In December, about 4.162 million people lost (or left) their jobs, and 4.184 million were hired (this is the labor turnover in the economy) adding 20 thousand total jobs. Even with the decline in December, thought, job openings (yellow) are up significantly over the last year.

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So there is a connection between inflation and interest rates. Rising interest rates are a sign that more money is in circulation—i.e., the demand for its use is rising. And that is a good thing at present. But inflation is more closely connected to employment, and past history says that inflation only becomes a problem when we get close to full employment—which is in the 6 percent range. That last happened in 2006 at the top of the housing and credit bubbles. And we are a long way from that place today.

Harlan Green © 2010

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