The Illusion of U.S. Inflation

May 9, 2012

The battle cry for the past decade of the critics of U.S. fiscal and monetary policy has been “inflation is coming, inflation is coming!!”  Never mind that their warning lacks empirical support and includes serious contra-indications when compared with the historical trends of inflation compared to trends of growth  in real GDP, jobs, and population, as shown below.

% per year CPI GDP Jobs Population
1950s 2.1% 4.2% 2.2% 1.7%
1960s 2.5% 4.3% 2.8% 1.3%
1970s 7.4% 3.3% 2.4% 1.1%
1980s 5.1% 3.0% 1.8% 0.9%
1990s 2.9% 3.3% 1.8% 1.2%
2000s 2.5% 1.5% -0.1% 0.9%
Since 12/09 2.7% 2.4% 1.3% 0.7%

Stagflation is a misleading expression.  When U.S. inflation picked up in the 1960s and 1970s, the real U.S. economy was expanding at a solid and ultimately excessively rapid pace.  Recessions in 1973-5, 1980, and 1981-2 were inspired by tighter monetary policies implemented to reduce inflation. Concurrent episodes of high inflation and recession were engineered by policy design and essentially cyclical.  In the above comparison, there is no significant shift in economic growth over the three sequential decades from the 1970s to the 1990s to match the rise and fall of CPI inflation.  A quantum downshift in economic growth between the 1960s and 1970s was not reversed by the subsequent restoration of  acceptable price stability.

While there is wide agreement that inflation is a monetary phenomenon, the appropriateness of monetary policy depends on what is happening in the real sector of the economy.  Inflation worsens when monetary policy accommodates and promotes either excessive demand-pull pressure in product markets or cost-push strains in labor and commodity markets. 

Inflation in the 1970s was preceded by twenty years with economic growth averaging more than 4.0% a year.  It was inappropriate for the Federal Reserve in the 1960s and 1970s to often keep its key interest rate lower than inflation.  The backdrop is different now.  Growth became historically low well before the onset of the financial crisis in 2007 and ensuing deep recession in 2008-9, and inflation has been at acceptable levels unlike the various spikes that began in the late 1960s and early 1970s, long before quantitative tightening was introduced in 1979.  The U.S. labor market, furthermore, is much looser now than then.  Growth in jobs minus growth in population amounted to only 0.6% per year in the 1990s and then plunged to minus 1.0% per annum last decade.  In the 2-1/4 years since the end of 2009, that spread recovered but only to 0.6% per annum, still well below the 1.4% per year pace between end-1969 and end-1989.

Fixed income markets do not reflect fear that sharply higher U.S. inflation is right around the corner.  The ten-year Treasury yield averaged 6.65% in the 1990s, 4.45% in the 2000s, and 2.83% since the end of 2009.  The Treasury yield now is roughly a percentage point lower than its post-2009 mean and about 300 basis points below its level on August 8, 2007 when the financial crisis began.  On March 9, 2009 when equity prices bottomed, the 10-year yield of 2.87% was also significantly above the present level.  Markets are more worried about world recession than inflation.

Other factors argue against imminent inflation.  Despite of the sharp increase in the Fed’s balance sheet since 2009, money growth is not behaving as such did in 1920s Germany or other hyper-inflations like Zimbabwe in 2008-09.  The U.S. M2 money stock grew 6.8% at an annual rate between September 2011 and March 2012 and 5.3% in the year between April 2010 and April 2011.  The core personal spending deflator rose 1.6% in 2009 and 1.4% each in 2010 and 2011.  It climbed at a sub-target 1.5% pace over the most recent three full calendar years and increased less between 1Q10 and 1Q12 than it did between 1Q08 and 1Q10. 

Can historically low short-term interest rates until late 2014 coexist with continuing low inflation?  You bet.  Japan’s overnight call money rate hasn’t been higher than 0.5% since the first week of September 1995, yet that economy is still struggling to escape deflation.  This is a more recent and more similar example against which to judge America’s risk of stumbling into intractable inflation than the instances of Zimbabwe, inter-war Germany, or contemporary Greece (where inflation in fact is presently not high).  Those who want the Federal Reserve to raise the Fed funds rate back above 1.0% soon and federal government to impose a fiscal drag equal to 5% of GDP at the start of 2013 need to explain why Japan’s experience has no lessons for U.S. policymakers to heed and why their recommendation is better than the one being followed.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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