By David Blitzer, Chairman of the Index Committee
Inflation fears are everywhere except in the data. While the Fed keeps reminding us that the inflation rate is below their 2% target, analysts keep arguing that the Fed will miss signs of inflation. Any hint of rising prices anywhere - from the CPI to oil to the money supply - is highlighted while reports of little change are ignored. Is there actually less threat of inflation than most perceive? Why do so many investors expect inflation to appear any moment?
The numbers: The latest figures for the CPI and the Core (excluding food & energy) CPI are 2.1% and 1.9% in the 12 months ended in June. The Fed uses the personal consumption expenditure (PCE) and Core PCE deflators which show slightly lower 12 month numbers of 1.6% and 1.5%, also as of June. The chart shows all four series over the last five years, there isn't much of a trend either up or down. Whatever the numbers show, some will point out that we're looking at the past and what matters is the future. True, but the key factors that drive inflation don't give any reason for worry. Wages, salaries and benefit costs are one inflation factor - if employment costs rise, businesses will try to recover their costs in price increases. However, the government's Employment Cost Index for total compensation doesn't give any hints of impending inflation. Since 2010 it has averaged 1.9%, the last figure was 2.1%, the same pace reported in third quarter of 2010 and the second quarter of 2011. The price of oil is another key determinant of inflation. While oil prices are volatile, they don't show massive inflation dangers. Prices recently at a bit below $100 per barrel for WTI have ranged between $95 and $113 since August 2010.
Some see inflation as something of a self-fulfilling prospect - if everyone expects higher inflation then business will raise prices and consumers will rush to buy before prices go up and the result will be inflation. The University of Michigan Consumer Sentiment survey asks people what they expect for inflation. From the beginning of 2010 to June of this year, the average is 3.2%. Even though consumers expect slightly higher inflation than we've experienced, the expectation isn't raising the inflation rate. However, the difference between people's expectation and the actual numbers confirms that a lot of us do believe prices are about to rise more quickly in the future.
The continuing belief that rising inflation is around the corner stems from either economic theories or personal experience. It can be difficult to confirm or deny economic theories with data because the economy is continually changing. So, while theory should be judged by how well it explains the data, it is often accepted if it seems plausible or can be understood. The simplest theory of inflation is "too much money chasing too few goods causes inflation." Combine this with the Fed's quantitative easing that boosted the money supply and you will expect more inflation. But the inflation didn't happen. The theory missed that the Fed began to pay interest on bank reserves and banks responded by keeping large deposits at the Fed rather than lending them out and creating more money. There wasn't too much money where it would have mattered.
Most people don't attempt to forecast inflation with economic theory. Their expectations of the future economy, or tomorrow's markets, are based on their own past experiences. One large group which came of age in an age of inflation are probably still concerned about prices. The baby boom, born between 1946 and 1964, turned 18 years old in 1964 through 1982, a period characterized by rising prices, two oil crises and sky-high interest rates which ended when the Fed attacked double digit inflation with a deep recession. Today the baby boomers range from 50 to 68 years old and some are probably still worried that rising prices will outrun their savings.
Should we forget about inflation? Not completely. However, before we buy, sell or hold anything based on a belief of higher inflation, looking at the numbers would be a good idea. The numbers suggest that inflation is reasonably well anchored near but a bit below the Fed's 2% target. For the last few years the Fed responded to unemployment that was too high and inflation that is too low, with very easy money. At some point in the next year or so, the Fed may face inflation and unemployment both close to their targets of 2% inflation and about 5.5% unemployment. Then Fed policy is likely to change and the markets will react.
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