We now have the CPI and the Personal Consumption Deflator for April, and they show that inflation is running comfortably in the middle to the upper half of the Fed's desired range. As evidence, I offer the following charts that compare the year over year and 6-mo. annualized rates of inflation according to these two measures, using both the total and the core (ex-food and energy) versions of each:
In the 12 months ended April, the CPI rose 1.96%, and the core CPI rose 1.83%.
In the 6 months ended April, the CPI rose at an annualized rate of 2.13% and the core CPI rose at an annualized rate of 1.94%. This suggests that inflation pressures have increased a bit of late. Which, of course, runs counter to the prevailing belief that weak economic growth-such as we had in the first quarter-suppresses inflation. This further suggests that the Fed's model of inflation, which is grounded in the belief that a lot of excess capacity (e.g., a relatively high rate of unemployment and a relatively large "output gap") effectively inoculates the economy against rising inflation, may be faulty. I side with the monetarists on this: inflation comes from an excess of money.
Some years ago, the Boskin Commission found that the CPI tended to overstate inflation by as much as 1% a year. The BLS has since tinkered with and improved their methods, and more recently the CPI has tended to register about one-half of a percentage point higher than the more robust and generally more accurate Personal Consumption Deflator. In line with this, we see that the PCE deflator rose 1.62% in the 12 months ended April, and the core PCE deflator rose 1.42%, both being about half a point lower than their CPI counterparts.
Over the past six months, the PCE deflator has risen at an annualized rate of 1.59%, while the core PCE deflator rose at an annualized rate of 1.46%.
I like to round things off and generalize, so I conclude from the eight measures of inflation shown above that inflation is running somewhere in the range of 1.5% to 2.0%, and that it has picked up slightly in recent months. This is not alarming, but it does not lend much support to the Fed's aggressively accommodative monetary policy stance. Why do they have the pedal to the metal when inflation is running comfortably in the middle to upper half of their target range?
At the very least we can conclude that deflation is nowhere to be found in the official inflation stats. Whereas some of them were flirting with sub-1% inflation last year, that is no longer the case.
The above chart is arguably the best measure of the dollar's value against other currencies. As it shows, the dollar currently is relatively weak against most of the world's currencies: about 12% below its long-term average. A weak dollar is symptomatic of an oversupply of dollars relative to the demand for dollars, and that is the equivalent to a strong anti-deflation tonic. You don't get deflation when there is a lot of extra money floating around. You're more likely to see signs of positive and/or rising inflation with a weak currency.
Steve Ballmer's shockingly large bid of $2 billion for the Clippers suggests that there is a lot of money out there chasing relatively few sports assets. Could this be a harbinger of a generalized increase in prices in the future? I wouldn't be surprised if it proves to be. Financial markets have done exceedingly well over the past 5 years. Not only is there a relative abundance of dollars, there is now a relative abundance of savings and wealth.
Despite near-zero interest rates, U.S. banks have taken in $3.3 trillion in savings deposits since late 2008. This is symptomatic of strong demand for the relative safety of money and money equivalents. Strong money demand has effectively neutralized the Fed's easy money stance to date. Put another way, the Fed has engaged in QE in order to satisfy the world's seemingly insatiable demand for money.
As I've explained before, strong deposit inflows have provided banks the wherewithal to purchase the $2.9 trillion of bonds that they then sold to the Fed as part of its Quantitative Easing efforts. To date, it would appear that the public is content to hold $7.3 trillion in bank savings deposits yielding almost nothing, and the banks are content to sit on $2.6 trillion of excess reserves yielding only 0.25%. But if and when the demand for all that near-zero-interest paying money starts to decline, the public's desire to reduce their cash holdings could result in a significant increase in the price of things (e.g., real estate, commodities, cars, vacations) they would rather hold instead.
In short, there is a lot of money sitting on the sidelines that could serve as the fuel for higher inflation and faster nominal GDP growth. All it takes is a decline in the demand to hold the huge stock of money and money equivalents that exist today.
The first chart above shows Bloomberg's calculation of the market cap of exchange-traded U.S. equities, currently about $23 trillion, up from just $8 trillion a bit over five years ago. The second chart shows the market cap of all global equities, currently $64 trillion, which is up from $26 trillion just five years ago. The third chart shows the huge gains in the net worth of U.S. households, which have been fueled almost entirely by gains in financial assets. These add up to some very impressive gains in money and wealth. Perhaps the Ballmers and near-Ballmers of the world are feeling like they'd rather have some concrete possessions instead of all that money in their brokerage account. Ballmer's aggressive bid for the Clippers may be a sign that money demand is beginning to weaken.
As the chart above shows, the bond market is anticipating that CPI inflation over the next 5 years will average 2.0% per year (expected inflation is derived by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity). That's a pretty sanguine outlook, considering that the CPI has risen at an annualized rate of 2.3% over the past 10 years, and 2.1% over the past 5 years.
So far, so good: some signs here and there that money demand is beginning to weaken and there is a surplus of money developing, but no sign yet of any worrisome increase in inflation. But it seems to me that the pressures for higher inflation are building. It may take a while for inflation to show up in the official statistics, but for now there are growing signs of an abundance of money and wealth, and the beginnings of a weakening in the demand for money that tip the balance in favor of higher inflation in the future.
As I noted last year, the Fed's real objective with Quantitative Easing is to destroy the demand for money. They want to weaken the public's and the banks' demand to hold on to money balances and their equivalent by making cash a poor investment compared to other assets. They don't mind seeing equity prices rise, as that ought eventually to encourage people to take on more risk. After all, this has been a recovery dominated by risk aversion. The Fed wouldn't mind seeing inflation rise above 2%, and they probably wouldn't take corrective action until it got to 3%. But that's a dangerous game, since, as Milton Friedman taught us, the lags between monetary policy and the economy are long and variable.
Don't let quiescent inflation and a weak economy lull you into a complacent view of the future of inflation, and don't worry about deflation. Think instead about the weak dollar, a weakening in the demand for money, and very strong financial markets.