Is Inflation Here to Stay?

Sometimes pictures are better than words:


Hat Tip: WSJ

The "Bailout and Justify" Fed

I can't think of a Halloween in recent memory that fell on a day with such a heavy dose of economic news. Not only are we getting some of the standard fare -- ADP private payrolls, construction expenditures, the employment cost index etc. -- we are also getting some real substance with the FOMC meeting and the third quarter advance GDP figures. The end result, if this year carries on as it has thus far will probably be bad economic news followed by a great rally. Allow me to explain.


As you can see above, the market has priced in a 25 bip rate cut heading into FOMC day. I personally think the Fed could, and may try to "justify" another 50 bip cut. How would they do that? Well for starters they could point out that market conditions haven't stabilized enough to cushion the blow from an accelerating housing market decline. After all that resilient American consumer is only as resilient as the credit officer who signs off on his/her HELOC's and credit card applications.

The Fed's second "justification" option is to just point at the graph above and use dramatic works like "crisis" and "carnage" to describe the credit spreads. Surely there is something in that chart to scare the weak-hearted and spin a 50 bip cut!

The reason I emphasize the Fed's need for justification is to point out how closely Bernanke's Fed seems to be following Greenspan's basic policy, as summed up in the following Greenspan quote from September of 2004 (and pulled from Jeremy Grantham's most recent newsletter): "For the Fed to interfere in security speculation is neither desirable nor feasible," but "if a sudden correction in asset prices did occur the Fed's first responsibility is to protect . . . to provide ample liquidity until the crisis is past." In plain English, Greenspan's stance is that you can't stop speculation, but you must bail out the speculators before they hurt everybody else. The real key of course is to bail out the speculators, but justify your bailout to market participants in such a way that they don't increase their inflation expectations. While this "bailout and justify" policy seems to be the preferred option for Greenspan and Bernanke, it does have a fatal flaw; it is quite simply not the type of policy that will force market participants to accurately price risk and thus prevent future speculation (moral hazard).

Now I want to make it clear that I don't think these moral hazard problems are necessarily Greenspan or Bernanke's fault. I think that the Fed Chairman's incentives, at least during this little slice of history, are just not in line with staying hawkish on inflation during market corrections. Indulge me on this for a moment. Back in early September Martin Feldstein suggested at the Fed's Jackson Hole Symposium that a 100-bip cut in the Fed Funds rate could be rationally justified. When reading the quote below from Feldstein's speech try to imagine yourself as the Fed Chairman listening to this speech and slowly letting your scholarly inclination to "stay hawkish on inflation and tough on speculators" slowly drift away and start thinking more about how posterity will view you if you precipitated a painful recession:

The Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.

Wait a minute, hold the presses, since when did "Decision Theory" replace the Taylor Rule as the key factor in the Fed's decision making? While I don't think Marty was trying to illustrate the amazing power incentives have in encouraging moral hazard in Central Banking, he did a fairly good job of it. The acute pain of a recession is a far bigger and more salient pock mark on the track record of a central banker than that of a "longer period of slower growth." Just think, if you were Bernanke looking at the current state of the economy, and I was God and I offered you stability today followed by a "longer period of slower growth" or a 50% chance of a sharp recession that would likely be blamed on you, which option would you take? That's what I thought.

Following this line of thinking to its natural conclusion, it would also behoove an incentive-led central banker to underestimate the true inflation rate in the economy in order to provide more flexibility to cut rates in times of distress. And now we are at the truly scary part of all of this discussion. More and more scholars are starting to question whether the Fed's preferred inflation measures are truly capturing all the inflation out there in the economy. Jeremy Grantham -- a man who seems perenially worries about the market -- has not once been concerned about inflation for the past 20 years, that is until now:

For the first time in 20 years I am slightly worried about inflation. . . By the way, like many others I have an increasing distrust in the official inflation numbers.
For example, we have rising commodity prices and a very large deficit combined with a very weak currency, yet we have a decreasing inflation rate and one that is lower than that of many European countries with strong currencies. Very odd indeed.

Makes you wonder what exactly goes into the inflation calculation doesn't it? I'll tell you what. With what little I know about incentives it just seems to me that the Fed is more likely to cut big now and seek to justify than it is to rediscover its distate of inflation. I just hope all of you who have made it this far in this post have moved out of the dollar into commodities and emerging market stocks.

Sidenote: Just the other day Jim Rogers was quoted as saying: "It's the official policy of the central bank and the U.S. to debase the currency." While I think he was being a bit dramatic, I think he may have a very good point. China dropped its 'official' dollar peg 26 months ago and has allowed its currency to appreciate just 10% over that stretch. Now China is facing a serious problem: they are raising rates to fight rising inflation (6.2% in September, October numbers due in 2 weeks) and they are watching as the US lower rates (today) to fend off a recession. If the US is at 4.5% and China sees rates rise closer to 3.5 or 4% it won't be long before China's Central bank will actually be losing money if it continues to sterilize capital inflows. With the Fed in "decision theory" mode I might just follow Jim Rogers advice and start moving all of my assets into Renminbi . . .

Unemployment Rate Rises to 4.6%

Job losses in the manufacturing and construction sectors caused the US unemployment rate to tick up from 4.5% to 4.6% in the July BLS data. Wage growth was also largely contained. To economists slowing wage growth and a rise in unemployment may actually be good news. As the economy has cooled in the last few quarters the Fed has held the benchmark federal funds rate stable at 5.25% pointing to above target core inflation as its chief concern. A tight labor market, rising wages and slowing productivity led them to believe that a lack of slack in payrolls could lead to increased inflation as companies would offset their high labor costs with higher prices. A slowly rising unemployment rate and low wage growth could ease those concerns, giving the Fed more flexibility moving forward.

When the Fed meets next week I expect them to again hold rates steady at 5.25%. Bernanke will still list inflation as the chief threat to the economy. But somewhere in the back of his mind slowing growth, core inflation below 2% and a small uptick in unemployment are easing his inflation concerns. If all three trends continue, Fed reports by the end of the year should indicate a neutral stance between growth and inflation, though I do not expect a rate cut this year.

GDP Clocks In at 3.4%

The 2Q2007 advance GDP number was released today by the Bureau of Economic Analysis. At 3.4% it was above economist expectations, but it is still subject to revision. This is definitely a stronger number than in Q1 when the BEA revised GDP down to 0.6% from 0.7%. Combined, the economy grew at an annual rate of roughly 2% during H1. This is below trend growth and definitely falls into the 'growth recession' range. Here are the important details from the report:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.9 percent in the second quarter, compared with an increase of 3.8 percent in the first. Excluding food and energy prices, the price index for gross domestic purchases increased 1.7 percent in the second quarter, compared with 3.1 percent in the first.

Real personal consumption expenditures increased 1.3 percent in the second quarter, compared with an increase of 3.7 percent in the first. Durable good increased 1.6 percent, compared with an increase of 8.8 percent. Nondurable goods decreased 0.8 percent, in contrast to an increase of 3.0 percent.

The price data was good news because core inflation appears to be moderating as the Fed expected. This may give the Fed the flexibility to squeeze in a rate cut later this year if necessary. In fact the futures markets are predicting one rate cut by December.

The Real PCE numbers and durable goods numbers were dismal however and if consumers and businesses continue to slow spending that would have a severe negative impact on the economy. Taken as a whole todays report contained mostly good news, although some, including Nouriel Roubini remain quite pessimistic about H2.

The Fed and Energy Prices

There has been a simmering debate about whether the Fed is focusing on the right measurement of inflation. The Fed prefers to use core Personal Consumption Expenditure (PCE) in its Taylor Rule. Economists use core PCE to eliminate "noise" from the data. They do this by stripping out volatile food and energy prices, which the Fed has no control over. Critics like Barry Ritholtz like to call this "inflation ex-inflation", since the headline inflation numbers which include food and energy have shown higher inflation. Thus in the great inflation debate you argue either for the core or the headline inflation data. The key questions are:

Should a central bank accomodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule?

These are the questions that two economists -- Rajeev Dhawan and Karsten Jeske -- at the Federal Reserve Bank of Atlanta set out to answer, most likely in response to clamoring in the media that the the Fed was ignoring the average American consumer by ignoring food and energy prices. So what did Dhawan and Jeske conclude in their paper entitled "Taylor Rules with Headline Inflation: A Bad Idea." (I guess the title kind of gives it away . . .)

• While the central bank cannot completely shield the economy from an energy price spike, a monetary policy that responds to core inflation does better than one that responds to headline (total) inflation.
• The less weight given to energy inflation, the lower the impact of an energy price shock on GDP and subsequent inflation. In fact, the central bank can lessen the impact of such a shock by assigning a negative weight to energy inflation, so long as it remains vigilant on core inflation.
• Rebalancing between durable goods and fixed capital investment is key in explaining this unconventional wisdom.
• Results vindicate the claim of Bernanke, Gertler and Watson (1997) that a less aggressive response by the Federal Reserve to the energy price increases of the 1970s would have stabilized inflation without harming economic growth.

It seems the academics are not flinching from their stance that the core numbers are the more important numbers to focus on. Take that Barry Ritholtz! (Hat Tip: CXO Advisory)