Friday, March 16, 2012

Inflation

Now would be as a good a time as any to take stock of current monetary policy, commitments by the FOMC, whether existing policy commitments make sense given our recent inflation experience, and what we might expect for the future.

At this week's FOMC meeting, policy remained essentially unchanged. Recall that, at the January FOMC meeting, the Committee essentially committed to holding the policy rate - the key rate is the interest rate on reserves - at 0.25% through late 2014, at least. Jeff Lacker dissented again on this round, as he did at the January meeting.

The FOMC told us at the January policy round that the inflation rate it cares about is the rate of increase in the raw PCE deflator. At the most recent meeting, the Committee continued to be very optimistic about the future path for the PCE deflator, apparently. From the March 13 policy statement:
The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.
And:
...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
Further, my guess is that the FOMC thinks that, even if we start to see inflation rates that are somewhat alarming, it that it can control this inflation through the use of "reserve-draining" tools - term deposits and reverse repurchase agreements. The FOMC thinks it can have its cake and eat it too - without selling assets or going back on its "extended period" language. As well, the inflation forecasts the FOMC gave us here are very optimistic - PCE inflation rates of 1.4% to 2% going out to 2014.

So, the key messages from the Fed's current policy stance are:

1. Don't worry about the possibility of more inflation coming from oil price increases, or other commodity price inflation. That's only temporary. Just like last year.
2. We believe in the Phillips curve. Not to worry. Plenty of excess capacity out there.
3. FOMC forecasts tell us that inflation is going to remain well below the inflation target of 2%. Trust the FOMC.
4. Even if inflation starts looking pretty bad, the Fed can control it, without raising the policy rate.

Well, if I were Ben Bernanke, I would now be seriously worried. But I'm not Ben Bernanke, and I can buy TIPS, so I'm not worried, as I'm insured.

What would I be worried about, if I were Ben? After our 1970s experience, and a reading of Atkeson and Ohanian, I'm not sure why anyone thinks of inflation forecasting in terms of Phillips curves. As well, even if I were to swallow the Phillips curve - hook, line, and sinker - there are good reasons to think that there may not be any excess capacity out there. Further, in the data I'm looking at, I see plenty of reasons to think that we are in for more inflation, and one of those reasons has to do with the Fed's wishful thinking about the power of reserve-draining tools.

The first chart shows you what our recent inflation experience is. I'm showing you raw pce inflation, and core pce inflation (year-over-year % rates of change). Though raw pce inflation is coming down, it is currently above the Fed's (now explicit) 2% target. Of course, the Fed takes its dual mandate seriously, but for an inflation rate of 2.5% to 3% to be acceptable, we have to think that we are currently well below capacity. That's not clear.

In terms of conventional monetary aggregates (not including the monetary base - we know why swaps of reserves for T-bills are currently irrelevant), what we see is in the second chart. This would certainly alarm an Old Monetarist. Year-over-year percentage rates of increase in currency, M1, and M2, have been increasing since early 2010. The rate of growth in M2 is close to 20% per annum, and for currency and M1, it is close to 10%. A quantity theorist would not think of those numbers as commensurate with 2% inflation.

Of course, we're not Old Monetarists, are we? A New Monetarist thinks that, under current circumstances (a large stock of excess reserves, and the interest rate on reserves - IROR - determining short nominal rates) the inflation rate is determined by the demand for and supply of the whole gamut of intermediated liquid assets - including Treasury debt of all maturities and asset-backed securities. We can't even measure everything we want to in that respect, including shadow-banking activity. For all we know, there may be a lot of substitution going on between observed and unobserved intermediation activities. Still, the second chart does not make me optimistic about inflation.

What about measures of anticipated inflation? The next chart shows the breakeven rates implicit in 5-year and 10-year Treasury bond yields and TIPS yields. There's nothing much alarming in there, though there has been a modest increase recently in these breakeven rates, which are close to where they were pre-financial crisis. Keep in mind, though, that in early 2007 the fed funds rate was at 5.25%. It's now below 0.25% (with the IROR at 0.25%), so if we really think that we have to adjust downward our notion of current capacity in the US economy, this would tell us that the policy rate should be higher. This reasoning is of course predicated on pre-crisis policy being optimal. That's a leap, but you have to start somewhere.

Finally, I think that, in line with this idea, reverse repos and term deposits at the Fed are irrelevant currently. If quantitative easing (QE) is irrelevant at the margin, reverse repos and term deposits cannot make any difference either, at the margin. If the Fed does enough of those things, of course, that will make a difference. But we're talking about $1.6 trillion worth.

Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise. The Fed can control the inflation, if they want to, but only if they increase the IROR, which they are loathe to do.

39 comments:

  1. Hi Steve,

    I think your link to Atkensen and Ohanian is broken. Here is a link: www.mpls.frb.org/research/qr/qr2511.pdf

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  2. Steve,
    I believe you meant "$1.6tr worth" in the second to last paragraph.

    I wonder why the Fed even talks about reserve repo's? Its either a purposeful con job on markets, or the Fed doesn't understand how little reserves are needed to support even a doubling of lending. Neither seems a particularly attractive explanation.

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  3. Hi Steve,

    Three questions: 1) given what seems to be your pretty confident expectation of "serious inflation," and "maybe sooner than later" at that, why not short bonds rather simply buying TIPS? 2) how do you explain the low market measures of anticipated inflation? and 3) what do you suppose explains the divergence between your "forecast" and the implied "forecasts" in the TIPS/Treasury relationship?

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    Replies
    1. 1. Sure, short nominal bonds, if you know how to do that.
      2 and 3. The market trusts the Fed apparently. I think it's wrong.

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    2. 1. Silly me. I did go short on nominal bonds as well. I have a large mortgage, refinanced several times, and now held by Fannie Mae.

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    3. There are exchange traded funds that allow you to short treasuries (TBF and TBX to name a couple). These ETFs attempt to deliver the inverse of daily returns on, for example, the Barclay's Capital US 7 - 10 year US Treasury Index.

      TIPS just seem like such a bad deal with negative yields going out to 10 years.

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    4. If the assets are all priced appropriately, one approach to betting on inflation can't be better than any other. On the TIPS yields: Yes, the yields are negative, but of course the idea is that the payoff comes from the payment you get that is contingent on the CPI. Further, if expected inflation gets revised upward, you get a capital gain if you are holding TIPS.

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  4. Steve: On this blog, you've made a distinction a prediction from a model and a forecast. Can this post be considered your 'forecast' for high inflation? If yes, what metric do you propose fo evaluate the out-of-sample percormance of this forecast?

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    Replies
    1. This is the best I can do for a blog piece written in the airport. Sorry, what you're asking for takes more time than I have available.

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  5. I guess if you predict serious inflation every spring you may be right sooner or later, although setting the bar for serious inflation at 2.5% to 3% is a bit of a cop out.

    From March 19th, 2011:

    http://newmonetarism.blogspot.com/2011/03/fed-and-inflation.html

    The argument is either that movements in volatile prices tend to be temporary, so we should ignore them, or an appeal to New Keynesian ideas, whereby we only care about the sticky prices, which are the non-volatile ones. Bernanke, in his Congressional testimony, takes the first route:

    ...the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation...

    My concerns here are the following: (i) Maybe these price increases are not temporary; with the world economy coming back (problems in Japan aside) and very strong growth in some places, resources in the world are becoming increasingly scarce. (ii) Inflation is inflation. I make the case here for looking at broader measures than core price indices.

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    Replies
    1. I don't make forecasts. I thought I was clear about that. I learn over time, and tell you what I think is going on. What's your forecast, Kyle?

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    2. Hello Steve,

      You have made it clear that you do not forecast, so I intentionally avoided the term, but you made a pretty concrete statement about your opinion of a future state.

      "Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way."

      I termed that a prediction (obviously conditional based on your concluding sentence), but will accept whatever terminology you prefer.

      My opinion is that the spike in oil prices is temporary because it is the result of factors unrelated to the consumption or supply of oil.

      If you go to the February 10th oil report on the IAE website, you will see that there isn't a shortage of oil supply, they have reduced their expectations of global demand, and they still have a fairly optimistic assumption of worldwide growth (Taken from the IMF of 3.3%). That's not the background for a sustainable increase in crude.

      http://omrpublic.iea.org/

      (the archives section on the left has all of the past reports)

      I also find this statement unconvincing:

      "The first chart shows you what our recent inflation experience is. I'm showing you raw pce inflation, and core pce inflation (year-over-year % rates of change). Though raw pce inflation is coming down, it is currently above the Fed's (now explicit) 2% target. "

      The chart that accompanied this statement clearly demonstrates why the raw data are nearly meaningless. There were several periods in which raw inflation exceeded 2% in your own chart without any sustained inflation, and if you expand your time horizon to include all of the historic data you see that it's a fairly rare event for the raw PCE Chained Index to ever fall below 2% YOY, and most of those were in the last 10 years, when the fed has often been accused of policies that encourage inflation.

      I expect crude oil prices (and measures of raw inflation) to increase through the summer as usual, then fall as reports of global GDP growth continue to disappoint.

      When the raw inflation numbers fall well below 2% later this year, we will not hear a word about that as a sign that the fed should be doing more to keep inflation from falling too far below 2%.

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    3. We'll just have to wait and see. I think I've been consistent in saying that the Fed can control inflation if it wants to, but I've had my doubts about its resolve. At this point, the FOMC has boxed itself in, and I can't see any other future scenario than more inflation in the future. How much? I don't know. 5% or 6% by the end of the year?

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  6. Steve: I assume, perhaps incorrectly, that economists and market participants whose view is informed by the New Monetarist Economics tend to expect higher inflation than the people now holding long-term bonds, not to mention those advocating more QE, an NGDP target, and/or more "fiscal stimulus."

    Since the information that informs these expectations seems to be available to everyone, their divergence can be traced to different models, formal and informal. It's just this diversity of views, not just of preferences, etc., that would seem to create headaches for those building representative agent models, not to mention models whose agents are in possession of "the model" (since there seem to be several).

    Or is it, as you seem to suggest, all just a matter of whether you trust the Fed or not?

    ReplyDelete
    Replies
    1. You can try to write down a model where heterogeneous agents have diverse beliefs, and everyone is optimizing. That's a very hard problem. I wish you luck.

      "...create headaches for those building representative agent models..."

      I don't think I have a published paper with a representative agent in it. You can go check if you want.

      Here's what to look out for. Track house prices, and the breakeven inflation rates from nominal bond yields and TIPS yields. The time to start worrying seriously is when you see large increases in both. At that point, market participants have ceased to trust the Fed, and we are in big trouble.

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  7. Unfortunately I am not as optimistic as you are that monetary policy will inflate house prices.

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    1. I did not say that monetary policy would inflate house prices. I'm talking about the relative price of houses. That will start to increase as the recovery takes hold.

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  8. With no well developed theory of inflation, no empirical tests of said theory, nor any way of determining the utility consequences of inflation across a heterogeneous population, this all seems like a lot of highly speculative hot air frankly.

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    Replies
    1. The well-developed theory is in my published and forthcoming work. If you want measures of the costs of inflation, you can find those in the literature.

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  9. Again, that would be a very desirable outcome.

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    Replies
    1. Sure. The problem is that the Fed has committed to a policy that won't work to achieve its goals.

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  10. Steve,

    Why do you distrust the Fed but trust the government (not to cheat you on CPI)? As the story of the Argentine government manipulating CPI has now made it to the mainstream press (http://www.economist.com/node/18587317) I'm curious.

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    Replies
    1. The Fed isn't hiding anything. I just think they don't know what they are doing. Further, I trust the US government agencies to report the statistics correctly. We can of course question the measurement methodology, but to my knowledge there has never been any indication of cheating at the BLS. We are not Argentina, in that respect.

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  11. Can your inflation theory be viewed as the equation of exchange, MV = PY, with velocity (V) being a function of alternative intermediated liquid assets?

    KP

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    Replies
    1. Why would you want to think of it that way? The "equation of exchange is just an identity, which defines velocity. In this case V will be a function of a bunch of stuff. That doesn't help.

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  12. Prof Williamson:

    Maybe I have this all wrong, but I was thinking that the low nominal interest rates we have might be good, since that's what I vaguely remember about the "Friedman rule." Shouldn't we be happy that we're sort of following this rule now? Or is the reason you're not ok with the current situation that inflation expectations could rise very fast, and push nominal rates up very quickly? Thank you.

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    1. You can have low nominal interest rates, and not be in a Friedman-rule monetary policy regime. See this:

      http://www.artsci.wustl.edu/~swilliam/papers/web%20page%20paper.pdf

      In my model, the nominal interest rate can be zero forever, and that can be consistent with any long run inflation rate, given that policy is adjusted to support that equilibrium. The nominal interest rate is also zero at the Friedman rule, which can be supported in various ways. The paper also gives you some reasons why we should want to be away from the Friedman rule in the long run (positive nominal interest rate).

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  13. Friedman believed that velocity was a function of the interest rate. Can this idea be generalized to the rate that clears the whole gamut of intermediated liquid assets?

    KP

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    1. No, the money demand function is not a structural object.

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    2. I'm not an expert in monetary policy but I sympathize with the view of KP.
      I don't know how much to worry about the increase in monetary aggregates.
      The opportunity cost of hoarding cash for firms and households might be low now and, most likely, those balances may stay idle for some time

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  14. the inflation view "5% or 6% by the end of the year", and the reference to monetary aggregates appears highly dismissive of the role of expectations. Especially when we know there are lots of near-money substitutes out there and money aggregates themselves can be misleading.

    First, right now tens of millions of employees are getting their annual "merit" raise which is going to be on average 1.5%-2%. Every CFO is the country is going to tell you that employee costs cannot rise faster than revenues. So why are CFOs approving a ~1.7% increase? Because economists told them thats what to expect.

    Because the Fed has a highly credible 2% inflation target.

    Its frustrating to see elite macroeconomists (who generally believe that expecations drive demand inflation) choke on this issue.

    A credible central bank that creates a 2% inflation target will get it, even in the face of high unemployment and an output gap!

    "sticky wages" only explain why its positive, not why its magically close to the Fed's 2% target (CFOs and HR have a lot of tools to throttle real employee costs & benefits to keep costs in line).

    its not hysteresis or some other made-up nonsense. it expectations wot did it

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  15. This post is full of falsifiable claims. Bless you, Stephen Williamson. I think you are wrong, but we have a shot at seeing.

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    1. we have to come up with ever-new theories when the same old sticky wages and 2% inflation target explanation does the trick. still waiting for that big inflation.

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    2. Sticky wages do not, I repeat do not, imply that inflation should be positive. dwb is rather stupid, and belongs in remedial economics classes with JLD and Serlin and the rest of the retards.

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  16. Hi Stephen Wiliamson.I have a question for you are : how to assess inflation expectations high or low?
    I live in a country suffering high inflation.This occurs after we have applied the wrong policy, include: excessive expansion of money supply, increased public spending, ... according to the advice of the Keynesian. We have high inflation and high unemployment. We aim to reduce inflation expectations to end the current situation.

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  17. Any second thoughts?

    Over the past sixteen months, the situation has definitely not developed to your intellectual advantage, has it?

    Perhaps some marking-of-beliefs to market is in order?

    Yours,

    Brad DeLong

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    ReplyDelete