Inflation

Now would be as a good a time as any to take stock of current monetary policy, commitments by the FOMC, whether existing policy commitments make sense given our recent inflation experience, and what we might expect for the future.

At this week's FOMC meeting, policy remained essentially unchanged. Recall that, at the January FOMC meeting, the Committee essentially committed to holding the policy rate - the key rate is the interest rate on reserves - at 0.25% through late 2014, at least. Jeff Lacker dissented again on this round, as he did at the January meeting.

The FOMC told us at the January policy round that the inflation rate it cares about is the rate of increase in the raw PCE deflator. At the most recent meeting, the Committee continued to be very optimistic about the future path for the PCE deflator, apparently. From the March 13 policy statement:

The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.

And:

...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Further, my guess is that the FOMC thinks that, even if we start to see inflation rates that are somewhat alarming, it that it can control this inflation through the use of "reserve-draining" tools - term deposits and reverse repurchase agreements. The FOMC thinks it can have its cake and eat it too - without selling assets or going back on its "extended period" language. As well, the inflation forecasts the FOMC gave us here are very optimistic - PCE inflation rates of 1.4% to 2% going out to 2014.

So, the key messages from the Fed's current policy stance are:

1. Don't worry about the possibility of more inflation coming from oil price increases, or other commodity price inflation. That's only temporary. Just like last year.
2. We believe in the Phillips curve. Not to worry. Plenty of excess capacity out there.
3. FOMC forecasts tell us that inflation is going to remain well below the inflation target of 2%. Trust the FOMC.
4. Even if inflation starts looking pretty bad, the Fed can control it, without raising the policy rate.

Well, if I were Ben Bernanke, I would now be seriously worried. But I'm not Ben Bernanke, and I can buy TIPS, so I'm not worried, as I'm insured.

What would I be worried about, if I were Ben? After our 1970s experience, and a reading of Atkeson and Ohanian, I'm not sure why anyone thinks of inflation forecasting in terms of Phillips curves. As well, even if I were to swallow the Phillips curve - hook, line, and sinker - there are good reasons to think that there may not be any excess capacity out there. Further, in the data I'm looking at, I see plenty of reasons to think that we are in for more inflation, and one of those reasons has to do with the Fed's wishful thinking about the power of reserve-draining tools.

The first chart shows you what our recent inflation experience is. I'm showing you raw pce inflation, and core pce inflation (year-over-year % rates of change). Though raw pce inflation is coming down, it is currently above the Fed's (now explicit) 2% target. Of course, the Fed takes its dual mandate seriously, but for an inflation rate of 2.5% to 3% to be acceptable, we have to think that we are currently well below capacity. That's not clear.

In terms of conventional monetary aggregates (not including the monetary base - we know why swaps of reserves for T-bills are currently irrelevant), what we see is in the second chart. This would certainly alarm an Old Monetarist. Year-over-year percentage rates of increase in currency, M1, and M2, have been increasing since early 2010. The rate of growth in M2 is close to 20% per annum, and for currency and M1, it is close to 10%. A quantity theorist would not think of those numbers as commensurate with 2% inflation.

Of course, we're not Old Monetarists, are we? A New Monetarist thinks that, under current circumstances (a large stock of excess reserves, and the interest rate on reserves - IROR - determining short nominal rates) the inflation rate is determined by the demand for and supply of the whole gamut of intermediated liquid assets - including Treasury debt of all maturities and asset-backed securities. We can't even measure everything we want to in that respect, including shadow-banking activity. For all we know, there may be a lot of substitution going on between observed and unobserved intermediation activities. Still, the second chart does not make me optimistic about inflation.

What about measures of anticipated inflation? The next chart shows the breakeven rates implicit in 5-year and 10-year Treasury bond yields and TIPS yields. There's nothing much alarming in there, though there has been a modest increase recently in these breakeven rates, which are close to where they were pre-financial crisis. Keep in mind, though, that in early 2007 the fed funds rate was at 5.25%. It's now below 0.25% (with the IROR at 0.25%), so if we really think that we have to adjust downward our notion of current capacity in the US economy, this would tell us that the policy rate should be higher. This reasoning is of course predicated on pre-crisis policy being optimal. That's a leap, but you have to start somewhere.

Finally, I think that, in line with this idea, reverse repos and term deposits at the Fed are irrelevant currently. If quantitative easing (QE) is irrelevant at the margin, reverse repos and term deposits cannot make any difference either, at the margin. If the Fed does enough of those things, of course, that will make a difference. But we're talking about $1.6 trillion worth.

Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise. The Fed can control the inflation, if they want to, but only if they increase the IROR, which they are loathe to do.