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Don't Worry About Inflation
There has been a lot of attention devoted to new Fed policies and their
effect on inflation.
Most of the information presented by the media has showcased the extreme results, notably 1970s like inflation growth in the U.S. or 1990s deflationary growth in Japan.
The idea that inflation can grow like what we've become accustomed to over the last 20 years has been deemed impossible by most reports.
Unfortunately, it is very difficult to predict what the future holds for inflation. We cannot properly estimate global commodity demand and it is almost impossible to forecast an oil price spike that would be similar to last year's bubble.
However, we can examine movements in the more stable core inflation.
Using fundamental economic modeling, the odds of high inflation over the near term are extremely unlikely.
Further, the Fed's exit strategy should contain an improbable spike in consumer/investor demand that would normally increase inflation.
Unemployment and Inflation
The most widely used theoretical model for examining inflation has been the
Phillip's Curve. In most undergraduate macroeconomics courses, the Phillip's
Curve is depicted as the relationship between unemployment and inflation.
An increase in unemployment causes inflation to decline.
The fundamentals behind this idea are rather elementary. The increase in
unemployment lowers aggregate wages. With less income to spend, consumers can
only purchase a smaller quantity of goods. Competition among firms forces prices
to fall.
Obviously, with unemployment ready to break the 10% barrier, it seems
inflationary pressures would be at a minimum.
The above graph by the CBO shows the change in the year-over-year core PCE
inflation rate and the estimated contribution to the change in inflation rate
from the increase in the unemployment rate.
What's interesting from the graph is how long unemployment is expected to pull
inflation downward. Unemployment is not expected to reach full employment (i.e.,
4.8%) until 2015. Until then, inflationary pressures will be muted due to lower
aggregate income.
The CBO is currently forecasting a decline in the year-over-year inflation rate
until 2012 and only moderate inflation thereafter.
Output Gap and Inflation
We can look at this another way.
Instead of using unemployment we'll take a look at the output gap.
The output gap is the difference between actual output (GDP) and potential
output. Potential GDP is essentially GDP calculated using the long-term trend
growth rate of approximately 3%.
When the output gap is zero, the economy is producing at full employment.
If output exceeds potential, the economy is experiencing inflationary pressures
as unemployment falls below full employment. The opposite is also true.
As shown above, the output gap reached historical highs of $892 billion in 2009
Q2. To put the gap into better perspective, the gap is now 6.9% of GDP.
Thankfully, the gap will decline as GDP rises. However, the demand for goods and
services will still be constrained as aggregate incomes remain depressed.
Firms will not be able to induce higher prices until the gap recedes back toward
potential.
What About All That Printed Money?
The size of the output gap is one of the reasons why the Fed has introduced
quantitative easing over the last 12 months.
This easing has led to a large increase in the money supply.
The media has jumped on this as one of the main drivers of inflation. But is
this true?
Money supply has always been taught as a driver for inflation. As more
money enters the system, rates are driven down and more goods are purchased.
The key to this theory is that an increase in money supply equals an increase in
goods purchased.
In the current recession, the money supply has increased by tremendous amounts
however demand for money has slowed.
This is fairly obvious. Goods that require credit such as appliances, cars,
electronics, and even housing have fallen throughout the recession. Only after
the Cash for Clunkers stimulus package have we seen an increase in car sales.
The first-time homebuyers program has also been a key contributor to an slight
increase in home sales over the last month. Without these government programs,
consumer demand for credit driven goods would still be declining.
Further, the Senior Loan Officer Survey by the Federal Reserve has shown a
continued decline in demand for funding. What's interesting from the survey was
that not only has consumer loan demand fallen, but C&I lending demand has also
suffered. A run up in investment growth seems to be far in the future.
If money is not demanded, goods are not purchased, and inflation cannot
increase.
So inflation is not driven by the money supply, but by the demand for money.
The Fed's Exit Strategy
Those worried about high inflation rates think that once demand starts to pick
up, the large money supply will make it extremely easy for consumers to obtain
funds and thus inflation will rocket upward.
The odds of this happening are extremely low as the output gap and high
unemployment rate do not correlate well with a spike in either consumer or
investment demand.
However, let's say this does occur. The Fed is not going to sit back and watch
inflation take off.
They can easily pull back large quantities of money by ending their quantitative
easing purchases. This can be done by simply letting the Asset-backed Commercial
Paper Money Market Mutual Fund Facility, the Commercial Paper Funding Facility,
the Primary Dealer Credit Facility, and the Term Security Lending Facility to
end when their mandate is up. These programs were not instituted indefinitely
and are all set to expire over the next 12 months. The removal of these programs
will reduce "easy" money significantly.
They also can sell assets back to the marketplace if need be. The Fed has
approximately $800 billion dollars in "legacy" Treasury assets composing of TIPS
and nominal bonds and $450 billion in asset backed securities. The liquidity
constraints imposed by the market on these assets should ease significantly as
the economy rebounds. Demand should become more stable and the Fed can reduce
the money supply by selling the securities back to the investors.
In a worse case scenario, the Fed can also drastically rein in the money supply
by increasing the required reserve ratios. This tends be thought of as the
nuclear option due to the disastrous effects shown after the Great Depression.
However, the Fed has given every indication that it has learned from that
experience and will make sure that any increase in the reserve requirements will
not cause the lending markets to seize up.
The Fed understands that high inflation is creeping into consumer inflation
expectations. The Fed has every intention of keeping inflation under control.
The Market's Inflation Expectation
So far the market has not let inflation become too much of a worry.
The above graph shows the 5yr-5yr forward inflation expectation breakeven. The
inflation expectation was calculated using differences between TIPS and nominal
Treasury bonds. The expectation does not account for the liquidity premium
associated with TIPS bonds, but premium is currently minor.
The expectation shows what the market believes the average annual inflation rate
will be for 5 years, 5 years from today.
The Fed's unofficial target for the CPI is somewhere between 2% and 2.5%.
According to the breakeven rates, the market is expecting the Fed to maintain an
inflation rate within target.
The market does not expect inflation to become a problem.
What It All Means
Media reports suggest high inflation is on the horizon.
Given the size of both unemployment and the output gap, the theoretical models
suggest inflation to be muted in the near term.
The increases in the money supply should not pose much of a threat to inflation,
and if demand for money suddenly increases, the Fed has the ability to reduce
the money supply without affecting general lending conditions.
The market understands the possibility of higher inflation, but right now,
believes future inflation growth is under control.
Feeds!