The Wall Street Journal (WSJ) is reporting a few days before the Federal Reserve’s next forecast round is scheduled to begin about the Fed being in two minds about inflation. One can only wonder how it got that inside scoop. Even the Fed’s transparency is shadowy. Still, the purport of the report is timely and perhaps can shed some light on the shadows with a policy regime change from implicit to explicit inflation targeting.
The Journal is saying that the “extended period” decision of the Federal Open Market Committee (FOMC) at the last two FOMC meetings appears to be justified by the Fed’s preferred measure of inflation: the core personal consumption expenditures (PCE) index, that excludes food and energy, released by the Bureau of Economic Analysis (BEA) has only risen by 1.3 per cent year-on-year.
Along with the text of the article, the journal has a nice chart for current inflation, showing a remarkable dip in inflation from its peak of about 2.7 per cent in mid-2008 to a current low of 1.3 per cent, only rising above 1.5 per cent into the Fed’s supposed comfort zone of 1.5 to 2 per cent at the beginning of 2010. The chart appears to be wrong. It shows a decline in inflation which is a statistic that requires close examination, whatever the measure: CPI or PCE.
Even if benefit of doubt is to be given to the chart and the BEA data, the question that must be asked is “why is inflation rising slower?” The real gross domestic product (GDP) of the United States consists of personal consumption expenditures (C), government expenditures (G), private investment (I) and the number (negative or positive) of exports less imports (NX). If NX is negative it subtracts from the rest (as it currently does) and vice versa.
Inflation could rise with the consumption component C if nominal GDP (or unadjusted for inflation against some arbitrary base year that the BEA picks, the most recent base year change being 2007) is used for the purposes of analysis. BEA data shows a trend of consumption falling by an equivalent amount of imports reduction. Exports are rising, raising the net of exports and imports. This means, Americans are selling more goods and services in foreign markets relative to consuming what foreigners make inside the country’s borders. This reduction in consumption is leading to the slowdown in the rate of increase of inflation.
The journal article is reporting that the real equilibrium interest rate or the difference between the Fed’s nominal rate (i) of money supply (which is currently between 0 and 0.25 per cent) and any inflation measure (CPI or PCE, headline or core) could rise in the long run and that this is the concern of the inflation hawks on the FOMC. Clearly, any number greater than 1 for inflation (π), whatever the measure, when subtracted from the near zero interest rate on money supply, yields a negative number for the real equilibrium interest rate (r).
Negative r means the economy is experiencing a net price decline or that it is deflationary, not inflationary, which validates the FOMC’s decision to hold interest rates low for an extended period. Therefore, the decision is not in question. What is at issue is the Fed’s communications about that decision in the context of the evolving economic circumstances.
Of concern to the Fed must be, taking the data and the Fed’s preference for the core PCE inflation measure to face value, the deflationary trend in spite of money supply being expansionary for already an extended period of time. It is true that financial institutions are still recovering and domestic real investment is low leading to persistent near double-digit unemployment even as the economy is showing signs of recovering.
The slow economic recovery, amidst persistently high employment and foreclosures, points to falling personal consumption and potentially dampening consumption in the future if employment is not created soon. And this is a greater risk to the U.S economy given that consumption makes up more than 60 per cent U.S GDP. Further, it also shows that should consumption rise in the future, imports could rise, depressing GDP if exports do not rise, unless the cheap dollar and higher domestic investment can, at a minimum, substitute for imported goods by producing the same competitively domestically. Also, should consumption rise, either due to domestic production or due to higher imports, oil prices would rise given the global oil markets, leading to more inflation. Therefore, on balance, unless the domestic U.S economy becomes persistently deflationary, inflation will rise.
The Fed’s doves are arguing, per the Journal article, that because core PCE is low and below the Fed’s target range of 1.5 to 2 per cent core PCE, inflation is not a threat. The CPI or the Bureau of Labor Statistics (BLS) consumer price index shows that inflation is also within the Fed’s comfort zone. The Fed has been known historically to prefer a measure opportunistically to suit policy judgments made ex ante. It would therefore also bring into question BEA’s data quality raising questions as to whether the United States government is publicly sticking to an academic inflation target while surreptitiously hiding inflation in public data subject to future revisions (similar to China) to bring down its real cost of debt servicing.
The Fed’s ex ante judgment is to leave the interest rates unchanged. Further, the country is facing a high debt burden. The interest costs to the U.S government on its long term debt are rising and only expected to rise as government borrowing increases. This means, the price stability part of the Fed’s mandate is currently being satisfied. The government is seeking patience with the high level of unemployment. And long term rates are rising, but are moderate.
Inflation expectations, however, are uncertain. And so is the expectation of long rates. This is so because, as the global economy recovers, whether the United States recovers or not, energy and food prices will rise. If the U.S economy does not recover or its growth rate tepid around 1.5 to 2 per cent of real growth as originally forecast by the Fed for 2011, government debt rises and long rates will rise. This means, the spread between borrowing short and lending long rises. The yield curve will be steeper suggesting more conventionally that the economy must recover due to higher domestic investment. This seems to be the reasoning behind the administration’s optimism for the long run. However, that optimism must not be misplaced, blinded to the risks involved.
The singular risk is that domestic investment may not rise. U.S financial markets could most likely lend long in foreign countries borrowing cheap money domestically, similar to Japan’s predicament since the bursting of its real estate bubble toward the beginning of the ‘90s, further depressing the dollar with the tail of exports having to wag the dog of the rest of the economy.
This scenario leads to the larger tail risk of consumption further falling in the United States and unemployment rising even more, leading to a double-dip recession as Wall Street double-dips with cheap dollars borrowed domestically after the bailouts and fat returns in the emerging markets. The ideology driving this trend out of the World Economic Forum (WEF) in Davos, Switzerland, seems to be that the emerging markets growth must first be captured over the next decade or two even if it is at the expense of domestic investment and employment, as if the two are substitutes, to integrate Brazil, Russia, India and China (BRIC) completely into the global economy, meaning, their currencies would, at the end of the process, float freely similar to the G7 currencies.
The overarching reason seems to be the energy market. If the G7 grew just as rapidly as in the late ‘90s energy and food prices would rise to the pre-recession 2007 levels, so the G7 consumer is being held back on both consumption and employment through the social safety nets as the emerging markets are allowed to prop up the global business cycle. This also suits the ideological shift to the left, globally, after the election of Barack Obama in the United States because the budget deficits of most of the G20 countries would rise, including that of China, by 2020, mitigating any risks to the U.S dollar.
The question, however, remains: why should the major emerging markets ― Brazil, Russia, India and China (BRIC) ― let G7 investment in even if their elites have been coopted at Davos when the process of international economic engagement is itself is a charade? United States and the European Union must learn or be forced to forecast the prospects of their economies and the standards of living of their peoples based on their own factors of production.
It is in the best interest of the rest of the G20 countries to trade with each other, leaving the G6 countries comprising the United States and Europe to their own devices and shed themselves of all their G7 (minus Japan) assets (debt) and obligations (currency reserves) by 2020. Japan’s recovery through Asia would be welcome given its prolonged bout with deflation and stagnation.