- Fed has good reason to set a 2% inflation target.
- Fed is committed to tightening if inflation goes above 2%.
- Lagged effect of money growth threatens 2.5% inflation or higher within a year.
- Inflation may end bull market soon.
Low inflation has given the Fed latitude for a very accommodative monetary policy. The influence of money growth on inflation probably means the latitude goes away within a few months. Tightening may be deemed necessary within a year. Below we will look at why 2% is a good inflation target and why price increases should push above that target within a year.
An inflation rate of about 1.2% appears to maximize economic growth. However, deflation is harder on growth than inflation. The Chart below shows the growth rate and inflation rate for each year from 1920 through 2013.
The red best fit lines suggest an optimal range for inflation is between 0.3% and 4%. A 2% target roughly hits the middle of this range shown in yellow. Inflation in 2013 was spot on the optimal level for growth. The weaker growth that occurred might be explained by my unconventional view of fiscal policy.
If the Fed aimed for the 1.2% that appears optimal it would increase the risk of being behind the deflation curve in a recession. For example, in the great recession the year over year inflation in core personal consumption expenditures dropped from 2.3% to 1.0%, yet we still had deflation as the price index fell in each of the last three months of 2008. Missing the inflation target on the downside is more dangerous to the economy than missing it on the high side. The chart above suggests that 1% deflation is about as damaging to growth as 7.5% inflation.
The Fed would like to get the inflation rate up to 2% before the next recession starts. They have taken aggressive steps to move toward that goal.
If inflation overshoots the target Janet Yellen's statement on April 16, 2014 suggests the Fed will also have a vigorous policy response.
"…of course, the FOMC absolutely will be committed to protecting inflation if it threatens to rise persistently above 2% as well. And, you know, I hope it's completely clear that while monetary policy is very accommodative at this point, and I focused on the need to keep it so or to adjust it to make sure the recovery remains on track, as the recovery proceeds and healing occurs, it's obvious we will need to tighten monetary policy to avoid overshooting our target. We are very focused on that."
Given this commitment, if inflation rises to 2% policy will be less accommodative. If it is above 2.5% for several months policy could tighten.
Case for Rising Inflation
The lagged effect of rapid money growth in 2011 and 2012 should push inflation above 2.5% in the next year. The lag between money growth and inflation is long and variable. To increase the accuracy of the forecast I use a high degree of smoothing.
The chart above shows the year over year rate of growth in M2, the two year rate of growth and the 22 month moving average of the two year rate which is what I use to estimate inflation. Below are charts showing the correlation of M2 growth with inflation in core personal consumption expenditures, which may be the Feds preferred measure of inflation, and with inflation in the consumer price index or CPI. M2 is the most significant variable in the models of inflation that are also shown.
In the scatter plot above each dot represents the year over year rate of inflation in core personal consumption one month and the smoothed rate of M2 growth 22 months earlier. The red line shows the exponential fit which is presumably the influence money growth has on inflation. In the time series plot the blue line shows inflation and the red line is the estimate or forecast of inflation based on the exponential fit of M2.
Money growth suggests the rate of inflation will rise significantly over the next 16 months to a high of 3.5% in August 2015. This is based on the smoothed growth rate having reached 7.9% 22 months earlier in October 2013. You can see on the scatter plot that at about 8% money growth inflation has ranged from around 1% to 7%. This level of money growth can be a fulcrum point where inflation can swing either high or modest. The 1% inflation just mentioned happened in the mid 1960s and inflation rose rapidly after that.
While there is a chance for high inflation other influences have kept inflation below the rate suggested by money growth for most of the last 15 years. So instead of 3.5% I expect something closer to 2.5%. For the foreseeable future, other factors appear likely to hold inflation below the rate suggested by money growth. Of course that could change, for example, if the trade weighted dollar index were to trend down in coming months inflation might start to exceed the M2 estimate in the latter part of 2015 or early2016.
The other economic variables I use to estimate inflation do not have as long a lead time as M2 so the model of all the variables only predicts out to October 2014 and estimates inflation in core personal consumption will be 2.0%.
In a few more months the data for the model will probably have an estimated peak rate for PCE core inflation. I am expecting something around 2.5%.
The charts for CPI below are similar, but the smoothed M2 has a shorter lead time of 18 months and the 7.9% M2 growth suggests the headline inflation rate will rise to 4%. The model estimates 2.3% this October. I expect the high in 2015 to be about 3%.
Inflation's History and a New Paradigm?
Inflation and monetary policy have gone through several major changes. From 1750 to 1913 the price index was quite volatile with periods of high inflation leading into wars followed by long periods of deflation. There was no upward trend in prices. So the price of a basket of goods in 1913 was about the same as it was in 1750.
The ability to inflate the money supply began in 1913 with the creation of the Federal Reserve. This ability likely meant that prices did not fall as much after W.W I as they might have otherwise. Out of The Great Depression came an institutional conviction to actively prevent deflation. There were two recessions associated with the depression. The first one lasted 43 months and ended in March 1933. The unemployment measure of the time shot up to 25% and the price index dropped 27% from 1929 to 1933. The conviction to battle deflation was tested in the 13 month recession that ended in mid 1938. Unemployment spiked from 11% to 20%; industrial production dropped 32%, but the decline in the price index was held to about 5.5%.
Since then the biggest deflations were 3.8% following W.W. II and 3.5% during the great recession. I date the modern period of inflation to 1937 when the Fed first prevented significant deflation in the face of a steep recession. Since then inflation has trended up at an annual rate of 4.1%.
A question that is not completely answered is whether there is now an institutional conviction to prevent significant inflation as well as deflation. The Fed did not prevent bouts of double digit inflation during W.W. II and the 1970s. In the period, "From the end of World War II until the mid-1970s, the mandate for monetary policy was based on the Employment Act of 1946." according to former Fed Governor Laurence H. Meyer in a October 2000 speech.
The inflation spike in W.W. II is understandable since every previous major war brought a spike of inflation. The inflation spike in the 1970s may be that the employment act of 1946 did not create the institutional conviction to control inflation or it might be due to Fed chairman Arthur Burns either being politically motivated or easily manipulated.
A colleague in Georgia recently shared an encounter he had years ago with John Ehrilchman. In the conversation the colleague said he thought that the President got the kind of monetary policy he wanted. Ehrilchman related sitting in the Oval Office while President Nixon walked back and forth and waved his finger in Fed Chairman Burns' face demanding what the chairman should do. While this account is at least second hand, it is a fact that M2 grew at a double digit year over year rate in 1971 and 1972 leading into Nixon's reelection. Going into the 1976 reelection campaign for President Ford M2 growth under Burns went to double digits in 1975, hit its peak growth rate in April 1976 and remained at double digit levels through 1977. These two bouts of M2 growth correspond with double digit inflation peaking in November 1974 and March 1980.
Since the late 1970s Fed direction for monetary policy has been governed by the Humphrey-Hawkins Full Employment Act. Since this act, the long term pace of inflation has been getting closer to the 2% target. In the last 20 years it has trended higher at a 2.4% rate and only at a 2% rate in the last four years. The core inflation rate in personal consumption has only been 1.4% in the last four years.
Perhaps some combination of this act and the inflation of the 1970s gave the Fed institutional conviction to control inflation. It is unclear whether Chairman Burns was just a loose cannon or if the act gave the Fed more independence in some subtle way. The Fed seems to be more independent. All the significant increases in the rate of money growth since then appear to be legitimate responses to a weak economy. The blaring example of independence is Fed Chairman Volcker raising interest rates to the highest level since at least the Civil War to fight inflation and money growth while President Carter was running for reelection.
The next test of whether we have a new regime that will prevent high inflation will come with what happens to money growth during the next recession at its aftermath.
Modern Trend Better
The economy and stock market have performed better with the modern inflation trend than in the previous period. Real per-capita GDP, corporate earnings and the stock market have all performed better.
Since 1937 real per-capita GDP has grown at 2.2% versus only 1.3% prior to 1937. If you don't account for population, real growth is only slightly better since 1937 at 3.5% versus 3.3%.
Real earnings on the stock market have grown at 1.9% versus 0.9% in the earlier period.
The stock market after inflation and dividends is only modestly better returning 6.8% in the modern period compared to 6.2% in the earlier period.
One reason for the better performance may be that month to month changes in the consumer price index are more stable in the modern period. In the modern period the standard deviation in the month to month changes in the CPI (I use log differences) is about a third of what it was prior to 1937. So it is at least arguable that prices are more stable since 1937 even though there is an upward trend to the index.
Inflation to end Bull Market
The rate of inflation can have a significant leading influence on the valuation of stock prices (NYSEARCA:SPY). The best measure of valuation I have found, PEses, uses inflation adjusted stock prices like the Shiller PE, but uses single exponentially smoothed real earnings (as shown in the chart above) rather than the 10 year moving average as Shiller does.
PCE core annual inflation of about 1.63% appears to be the stock valuation maximizing rate. Stock valuation tends to fall following core inflation higher or lower than that. In looking at inflation above I use year over year rates of change. The correlations below benefit from the additional smoothing of using annual rates which take the average index of the previous 12 months and calculates the change from the average of the 12 months before that.
In the chart below each point on the scatter plot represents the PEses one month and the core inflation from 12 months before.
Core inflation hit the near optimal rate of 1.64% in April 2013 and has since plunged to a low of 1.2% in April 2014. This suggests that stock valuation could have peaked in April 2014 and the below optimal inflation would have a downward influence on valuation over the next 12 months. Based on the fit of core inflation to PEses 1.2% inflation implies a PEses of 34.2 which is 24% below the 45.0 PEses of this past April.
If the above forecast of core inflation rising to 2.5% comes that would be consistent with a PEses of 30.9. Getting to 2.5% inflation would of course mean going past the valuation optimizing 1.63%. However, if inflation is rising rapidly, as I expect it will, and the monthly changes are running at the plus 2% annualized rate I would not expect the stock market to respond as if inflation were at the optimal level.
Core inflation has a better correlation with valuation than the headline CPI rate and also has a longer lead time, but the CPI has a longer record. In the period since 1965 PCE core inflation and CPI inflation have a similar relationship to valuation. Prior to 1965 the relationship was much worse or was just distorted by other influences.
The period prior to 65 shows inflation can be at the optimal level, but still correspond with low stock market valuation.
Rising inflation may do its biggest damage to stock valuation by changing the perception that the Fed has the stock market's back and will launch another round of quantitative easing ("QE") if stock prices falter. Stock prices are not part of the Fed's mandate. If inflation is above the 2% target it would probably take a falling economy for the Fed to start another round of QE. If the economy is falling into a recession QE does not prevent a bear market in stocks, or at least it didn't during the last recession.
The downtrend of inflation rates for the last three years appears to be reversing. The 0.2% monthly increases in March for the PCE core and the CPI were 2.1% and 2.4% respectively on an annualized basis. Core Inflation in personal consumption expenditures will probably head up to around 2.5% in 2015. Headline CPI inflation should hit 3%, but is volatile enough that 4% is not out of the question.
If monthly inflation continues at annual rates above 2% for a few more months and M2 growth stays above 5% the Fed will almost certainly continue tapering and end quantitative easing on schedule. If headline inflation were to touch 4% or core inflation goes above 2.5% there might even be tightening.
Under difficult circumstances The Fed has kept inflation close to the level that normally maximizes economic growth. The Fed may have prevented much worse economic performance. In the past few years keeping inflation near the optimal required very accommodative policy. In the next year it may require tightening. At the very least inflation hawks at the FED should have much more to make noise about.
The elevated monetary base continues to create the potential for very rapid growth in M2, but based on M2 growth so far inflation above 4% in the next 3 years looks very unlikely.
The correlation of PCE core inflation and stock valuation suggests stock prices could have peaked in April. If as I expect, rising inflation means continued modest nominal GDP growth accompanied by faltering real growth and recession a bear market could be close at hand.
Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.