America’s Overstated Inflation Scare

November 13, 2012

Just about everyone knows that the Federal budget deficit soared in the Great Recession when revenues plunged.  Less widely understood is the fact that the gap has been subsequently grinding downward by about a percentage point per year and is now hovering around 7% of GDP.  Monetary policy has accommodated America’s weak economic environment.  Three rounds of quantitative easing have allowed the central bank’s assets to climb around 3.3-fold since the collapse of Lehman in September 2008.  This combination of deficit government spending and an expanding Fed balance sheet has generated fear of future inflation.  Even though a long-predicted spike in inflation hasn’t happened so far, forecasts of such remain abundant.

For many people, fear of inflation has a more concrete basis than a theory pointing to accelerating general increases in the prices for goods and services.  A number of conspicuous items in family budgets seem to be rising quickly, giving rise to the view that government data like the consumer price index are intentionally fudged or compiled in such a way as to systematically understate the true state of inflation.  The behavior of property taxes, gasoline, food and medical costs do not seem to support the contention of low, predictable, and stable inflation.

The Labor Department CPI data paint a healthier picture.  In the year to September, both total and core consumer prices advanced 2.0%.  Over the past five years, consumer price inflation has averaged 2.1% per year, down from 2.9% per annum in the prior five years to September 2007, 2.5% per year in the ten years to September 2002, 3.7% in the 10 years to September 1992, 8.8% in the 10 years to September 1982, and 2.7% per year in the fifteen years to September 1972.  Core CPI inflation of 1.7% per annum over the past five years is down from 2.0% in the prior five years, 3.8% per year in the five years to September 1992, 8.2% per year in the decade to September 1982, and 2.8% over the fifteen years to September 1972.

Nor do U.S. treasury yields reflect a rise in expected inflation.  The current 10-year yield of 1.59% is 21 basis points lower than its year-to-date average and even further below period averages of 2.76% in 2011, 3.19% in 2010, 3.65% in 2008, 4.39% in 2003-07, 5.30% in 1998-02, and 6.45% in 1993-97.  The 30-year bond yield of 2.73% is below its year-to-date mean of 2.93%, a mean of 4.85% as recently as 2003-07, and way below the average yield of 8.40% in 1987-92.

The inflation doomsayers are ignoring several bits of information that run counter to their thesis of a major inflation problem lurking just around the corner. 

  • There has been a big rise in money demand as well as money supply.  Put differently, the velocity of money is growing slowly.  In the quantity theory of money, inflation is postulated to be a function of the growth of MV (money times velocity), not money alone.
  • Because of a more stable dollar, import prices are better behaved.  From a low in July 2001 to the collapse of Lehman in September 2008, the trade-weighed dollar fell 37%, but the U.S. currency on such a basis is only about 3% softer over the subsequent four-plus years.
  • Domestic inflation increasingly is governed by the global environment, and disinflationary forces have been more prominent around the world than inflationary ones.
  • When citing historical precedents of loose fiscal and monetary policy that resulted in rapidly accelerating inflation, inflation hawks often mention the experiences of Germany after the First World War and of various Latin American economies later in the twentieth century, but they overlook the example that best parallels America’s present predicament, and that is Japan, which has experienced deflation since the late 1990’s despite government debt that has ballooned to 200% of GDP and an overnight central bank money rate target that hasn’t exceeded 0.5% since September 1995.
  • The greatest current aberration in the U.S. economy doesn’t involve the Fed or government deficit but rather the labor market.  Without a drum-tight labor market, which was the case in the 1960s run-up to the inflation that hit a decade later, it’s difficult to envisage a collapse of price stability. Candidate Romney often spoke of 23 million unemployed Americans, a figure obtained by adding counted unemployed workers and all others who’d like to work full time but are in part-time positions plus anybody who gave up looking for a job from discouragement but would be working now if the economy weren’t so weak.  Romney’s figure actually understates the problem, however.  Over the 20 final years of the 20th century, U.S. employment advanced by 1.84% per annum, and if such a pace had continued, there would now be about 165 million workers in the United States.  The shortfall in actual jobs against this theoretical trendline is 31 million workers, 21% greater than the entire population of Texas, the second most populous state.  31 million jobs also represents a 19% shortfall from full employment.

One area where fear of inflation has been extremely manifest is the price of gold.  Between the dollar’s trade-weighted peak in mid-2001 and the collapse of Lehman Brothers in September 2008, gold prices advanced by 194%.  This made some sense, because the dollar was falling almost 40% against its cocktail of other fiat currencies.  But in the subsequent years when the dollar has held its own in currency markets, gold prices have climbed by an additional 121%. 

Such appreciation in gold overstates the inflation danger in the U.S. and elsewhere in my view.  That’s not to rule out some pick-up in measured consumer price rises, which given the scope of the labor market deficit wouldn’t be a bad thing.  Federal Reserve officials have said as much.

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

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