By: Lou Brien
The Fed is mandated to create policies that are capable of sustaining maximum employment and at the same time keep prices stable. But there is a first among equals in this dual mandate; price stability matters more to the Fed. That’s because the level of prices and the path they follow shapes some of the key decisions made by businesses and consumers which in turn can play a role in determining the vitality of the labor market. Price stability is of course not a one way street. While inflation is the normal concern of central bankers there are times when the threat of deflation predominates and on those occasions it is the second among equals in the Fed mandate that must step up before the Fed can stand down on the possibility of generally declining prices, at least that is how I see it in the current situation.
The Fed has been chattering about their exit plan from the extremely accommodative monetary policy for several months, even tinkering with some of the facilities they expect will help them accomplish the task. Kansas City Fed boss Hoenig has been a dissenter at every FOMC meeting this year and is on record calling for a rate hike by the end of September. St. Louis Fed President Bullard says that he’s not worried about inflation springing up any time soon, but "in the medium term we do have very substantial inflation risk in the US because of substantial fiscal deficits and ultra aggressive monetary policy." There are other Fed policymakers who have also expressed similar concerns about the future path of inflation should the central bank stay too easy for too long. There is an undeniable logic to the inflation story; low rates, high excess reserves and a rebound in the economy make the case for a scenario of rising prices as easy as pie to construct. And that may be the reason why the persistent disinflation has been so difficult for some to swallow.
It was late in 2008 when the Fed expanded the Monetary Base by more than $1 trillion and contracted the Fed Funds rate to a range that includes zero as its lower boundary. The Core CPI was running at 1.8% on a year over year basis that December, it is half that now; the latest reading shows it at a forty five year low of 0.9%. The Cleveland Fed’s Median CPI, a measure of prices that is considered to be a superior gauge of the inflation trend, has fallen from 2.9% at the end of 2008 down to an annualized rate of just 0.5% in May. The Fed has taken note of the trend in its latest economic forecast. At the January FOMC session twelve of the seventeen meeting participants projected that the 2010 year end PCE Core inflation rate would be somewhere in the range of 1.1% to 1.4%; four others estimated that it could be as high as 1.7% to 2.0%. But at the April meeting eleven of the participants were projecting a year end rate in the range of 0.7% to 1.0%; in January there was only one estimate as low as 1.0%. The high guess at the April meeting was 1.5% to 1.6%. In my opinion this was a quantum leap down on the outlook for inflation and the price data that has been released since April has only served to reinforce the downward shift in the Fed’s view; for example, the current three month annualized rate for the CPI Core is way down at 0.4%. Let’s face it, after a year and a half of a zero bound Fed Funds, quantitative easing, enormous fiscal stimulus, a huge stock rally and three quarters worth of economic growth, inflation isn’t threatening to go too high, but rather, it is edging too low. So, what’s the deal?
I think it continues to be the case of, "Inflation! Who’s going to pay for it?" The inflationary episode of the seventies was led by strong income growth. Even the Weimar experience was characterized by wheelbarrows full of money necessary to buy loaves of bread, but the point is the consumer had piles of the worthless cash with which they could fill the wheelbarrows. The current situation is characterized by low wage growth and declining incomes when government transfers are removed from the calculation and a consumer sentiment about their finances that is at or near record lows. "When asked about their current finances, just 11% of all households mentioned recent income increases in early June, the second lowest level recorded in more than sixty years," says the University of Michigan survey of consumers, which adds, "Income expectations for the year ahead were as grim, as nearly six-in-ten consumers expected no increase at all in their nominal incomes." The survey also revealed that "when consumers assessed prospects for real income gains over the next five years, they judged their chance at less than one-in-three, the lowest probability recorded in the twelve year history of the question." The important thing to note is that this lowest ever result is being recorded more than one year after the depths of the global economic crisis were hit. Allow me to belabor the point. The Consumer Confidence report compiled by the Conference Board shows that for the first time in the history of their survey there are more respondents who think their income will decline than there are those who think it is going to rise. The trend started with this recession and although the differential was worse at the economic nadir it is an outlook that persists.
The logistics of inflation requires that consumers have the money to pay higher prices for goods and services and that they continue to buy similar amounts of those goods and services at the increasingly higher prices. Income must go up at a rate that is as fast, or faster, than the rate of inflation or credit must be easy and desirable to obtain to make up the difference. That was likely the case during the last decade when credit was fast and loose and sought after. But household debt is now amounts to more than ninety percent of the country’s GDP for the first time since the Depression; in 2000 household debt was about sixty seven percent of GDP and it was just over forty percent during the seventies. Households are not adding to their debt burden at this time they are shedding it. This is deleveraging and this is deflationary. In aggregate, households are income starved and overstuffed with debt and interest payments. I don’t know where the money to pay for inflation is supposed to come from. In the current circumstance higher prices means fewer purchases, pricing power does not currently exist and will not until hiring gets significantly better and aggregate income goes along for the ride. Price stability is the first among equals in the Fed’s dual mandate but I don’t see how that is achieved without the second among equals picking up the pace. There may be logic to the inflation story but I don’t think the math of the household budget supports it.
Inflation, no thanks, can’t afford it.
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Disclosure: no positions