SF Fed on Inflation, or better, the Lack of Inflation

Great speech by John C. Williams, Executive Vice President and Director of Research, Federal Reserve Bank of San Francisco, Presentation to the Seattle Community Development Roundtable. I’d recommend reading all of it, but there’s a section on inflation and QEII (my bold):

I’d like to turn now to inflation, or, I should say, the lack of inflation.  The measure of inflation we follow most closely is the core personal consumption expenditures price index.  These prices have been rising at a 0.9 percent rate so far this year.  This is the lowest nine-month inflation rate recorded in the over 50 years that this statistic has been compiled.  Our forecast is that inflation will come in about 1 percent for the year as a whole and stay at that rate next year.  That’s about 1½ percentage points below where it was at the start of the recession and well below the level of around 2 percent that most Fed policymakers have said is consistent with stable prices.

Mike here, quick break.  Yes I bolded almost the entire paragraph.  Inflation is much lower than it was before the recession.  It’s only at 1% and will be that rate next year as well.

And repeat after me: 2 percent inflation is consistent with stable prices. Inflation is under 2 percent. Prices are not stable. Therefore the Federal Reserve isn’t hitting it’s price stability mandate, even forgetting the maximum employment mandate.   It’s accomplishing 0% of its job, not even half of the dual mandate.

Back to Williams (still my bold):

It’s hardly a surprise that inflation is so tame.  There is a great deal of slack in the economy and workers are in no position to demand sizable wage increases.  And both consumers and businesses have learned to wait for bargains before making purchases.  Our retail contacts speak of a brutal sales environment in which heavy discounting has become the norm and holiday sales start around Halloween.

Figure 3: Rising Risk of Deflation
Figure 3: Rising Risk of Deflation

To me, the danger is that weak demand and excess productive capacity could cause inflation to fall further, taking us perilously close to deflation….Few of us have experienced an extended period of deflation, but it’s not pretty.  TheNew York Times recently ran an article about how ordinary Japanese citizens coped with deflation.  It described how people stopped buying homes, cars, and other discretionary items because they could be had for a cheaper price in the future.  Businesses postponed investments because the returns from holding cash were better than what they could reliably expect to earn by expanding operations.  The article conveyed a pall of gloom that hung over the Japanese economy, sapping confidence and further fueling a deflationary hesitance to spend…

Finally, and perhaps most importantly, we’re also different from Japan in monetary policy.  One lesson from Japan’s experience is the need to act aggressively before deflation becomes firmly entrenched.  In contrast with Japan, the Fed has adopted proactive measures to head off a deflationary spiral before it can take root.  This brings me to current Fed policy and, in particular, the recently announced program to purchase Treasury securities.

By way of background, it’s important to understand that by law Congress has charged the Fed with two objectives: maximum employment and price stability.  Currently, the Fed is falling short on both counts.  Unemployment obviously is unacceptably high.  And, as I’ve explained, inflation is somewhat below the level that is consistent over the long run with stable prices.  In other words, the Fed would like to kick the recovery into a higher gear and nudge inflation up a bit, avoiding further disinflation…

Fed’s latest program involves purchases of a further $600 billion of longer-term Treasury securities, which will be carried out at a pace of about $75 billion per month.  The idea is the same as before–to push medium and longer-term interest rates down further, giving added support to economic activity.  So far, the responses in financial markets show that this program is working.

Like all monetary policy decisions, there are risks associated with this action.  I would like to talk about the concern that we may see a return of high inflation because of the large amount of monetary stimulus.  Although I take this concern very seriously, I see the risk of high inflation as remote.  First, there are no signs of the kind of overheated economic activity that triggers inflation.  Indeed, all measures of slack I know of show the economy is running well below its potential and inflation is trending down, not up.  Second, the inflation expectations of households, investors, and economists point to low, not high, inflation in years to come.  In the 1970s, the last time we saw runaway inflation, inflation expectations had clearly become unmoored.  Third, the Federal Reserve has the means and, most importantly, the will to reduce monetary stimulus when appropriate.  As it has for the past three decades, and as it affirmed in the November 3 policy statement, it will monitor the economy carefully and adjust the stance of monetary policy to preserve price stability.

The Palin/Paul idea of hyperinflation is nonsense here. Inflation is trending downward, expectations are set to low inflation and the Federal Reserve is going to pull the plug well before inflation gets out of control.

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3 Responses to SF Fed on Inflation, or better, the Lack of Inflation

  1. I’m concerned Fed-critics will play word games with the way you and Williams use the word “stability”. To be pedantic, 2% inflation is NOT consistent with stability of prices, if you take the everyday meaning of the word. Stable, in everyday speak, implies zero inflation. I think what Williams meant was that 2% inflation is consistent with the Fed’s inflation mandate (which says something about “stable” prices). I think the Fed gets away with this because they’re interpreting their mandate as having low volatility of prices.

    To be honest, I’m not 100% sure why they interpret their mandate this way. One could argue that high inflation is more painful than volatile inflation. But with a target of 2%, its hard to make the case that that level of inflation matters. Also, the Fed believes, as do I, that their only job is to manage inflation expectations. I suppose they believe expectations are more easily managed by having non-volatile inflation.

  2. -g says:

    Hi Mike,

    I’d count myself as one of your less savvy readers…often I find myself having to read posts numerous times in order to understand what is written. And for the sake of transparency, I’ll just come out and say that I am pretty firmly on the left.

    I feel like we have been getting some mixed signals from from the variety of news sources regarding inflation. This comment is my way of asking for clarity on this issue. You have been pretty explicit in taking on education as a goal, and I look forward to your response. I also apologize for the length of this comment. I’m just sort of lost.

    The above post is making the case that inflation is not a problem. Got it. The metric being used however is “Core Inflation”. It seems to me (again, recognizing that I’m a novice) that “core inflation” is a suspicious metric. A, ’08 Harpers article noted “. If the Consumer Price Index was calculated by tracking a bundle of prices, so-called core inflation would simply exclude, because of “volatility,” categories that happened to be troublesome: at that time, food and energy. Core inflation could be spotlighted when the headline number was embarrassing, as it was in 1973 and 1974.” (Phillips, K. P., Numbers Racket: Why the economy is worse than we know. The same article quotes Barry Ritholz as saying the core inflation is “inflation after the inflation has been excluded.”

    What’s more the housing component of the CPI is arrived at through questionable means (btw, Sal Khan has a really good youtube video talking about the “Owner Equivalent Rent” classification which I’d link to but for the possibility that this would end up in your spam comment folder). Which is to say, the housing calculation can either be understated or overstated regarding inflation.

    Now, you and Paul Krugman and others are using the CPI to explain that inflation isn’t the problem. The thing is, other reliable commentators are noting that there is more to this story. On the community blog Metafilter, the user named “Mutant” (also a former worker in finance) points out the following:

    …we’ve been seeing evidence of significant PPI side inflation over the last six months or so. Here are just a couple of soft commodities – Sugar, up about 66% since June 2010, Wheat, up some 36% since June 2010.
    I’ve been presenting this data to my clients for several months now. Inflation is already here, most folks don’t see it as they don’t know where to look (only see it on the grocery shelf) and we see QE 2 driving more, of course.

    Later on, he posts:

    Across the board, most commodity indices have seriously risen, looking back one or five years. If we look at the UBS CMCI index, we see a 33% increase across the past year. Looking at the DJ UBS Industrial metals index, we see an almost 50% increase over the past 18 months. The CRB Commodity Index shows a 20% increase over the past 18 months.

    Now we don’t think this is driven by economic activity; GDP in most of the G7 has been terrible, and incidental indicators such as The Baltic Dry Index by now means show increased demand for shipping (i.e. raw materials being shipped to Chinese factories and finished materials being shipped to North America & Europe).

    If there was increased economic activity we’d expect to see this reflected in more frequently updated indicators (there are many we look at) besides the BDI.

    Now, I really don’t think that he is trying to sell his reports on the Metafilter site, but who knows? What’s more those commodities have seem price drops after he posted this. On the other hand, “Mutant” seems to, consistently over the years, have a pretty strong history of center-left responses. Which is to say, I’m inclined to believe that the responses are in good faith and also reliable (especially since he supports his facts with links).

    My point here is that to say that the CPI metric is suspicious and the Core Inflation metric is as well is defensible. FWIW, CNBC took a different tack on the inflation question (Melloy, J., Secret Walmart Survey Shows Inflation Already Here, CNBC.com, 11/11/10).

    So my question is, why should we take the CPI/Core Inflation figures seriously?

    I apologize if this question mixes myth with fact and thanks, in general, for being a great, great resource for those of us trying to make heads or tail of all of this.


  3. Pingback: Reuter’s Bad Arguments on Structural Unemployment, America as Sick Man. « Rortybomb

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