October 23, 2017
Where Has All the Inflation Gone? When
Will the Fed Ever Learn?
With apologies to Pete
Seeger
The Fed is dazed and confused (with apologies to Jake
Holmes) about the lack of goods/services price inflation currently present
in the U.S. economy. No matter how you slice or dice the Personal Consumption
Expenditures (PCE) Chain Price Index, its annualized growth has not trended above
2% since 2011. How can this be given that the unemployment rate of those
covered by unemployment insurance is at an historic low of 1.3% (see Chart 2)?
Wherefore art thou, A.W. Phillips
and your curve purporting to show an inverse relationship between the level of
the unemployment rate and the rate of goods/services price inflation?
Chart 1
Chart 2
Why the Fed is bothered by the lack of consumer price
inflation is a mystery to me. With whatever unemployment rate you choose
plumbing cycle, if not decade lows, why is the Fed concerned by persistent low
consumer price inflation? Is this not an outcome to celebrate rather than
despair?
Whatever the reason
for the Fed’s angst, with regard to the alleged inverse relationship (negative
correlation) between the unemployment rate and consumer price inflation,
try as I might, I could not find a consistent one. Starting with quarterly
observations from 1955, the best I could tease out of the data was a positive correlation of 0.05 (out of a
maximum absolute value of 1.00) when the four-quarter moving average of the
unemployment rate was advanced by four quarters (see Chart 3). In effect, the data show no consistent
relationship between the level of the unemployment rate and the rate of
consumer inflation over time – inverse or positive.
Chart 3
Not one to give up on A. W., I tried a variation on his
theme. The logic underlying the Phillips Curve is that the lower the
unemployment rate, the narrower is the gap
between actual real GDP and the economy’s potential real GDP. Potential GDP is a function of guesstimates of
the size of the potential labor force
and potential total factor
productivity. The hypothesis is that as actual
real GDP rises relative to potential
real GDP, consumer price inflation also should rise. That is, there should be a
positive correlation between the
relative gap between actual and potential real GDP and consumer price
inflation. And sure enough, I was able to find one using the Congressional
Budget Office’s estimates of potential real GDP. When advanced by five
quarters, the real GDP relative gap has a positive
correlation with the rate of consumer price inflation of 0.22 (see Chart
4). An absolute correlation coefficient of 0.22 is nothing to write home about
(remember, the maximum possible is 1.00), but at least this version of the
Phillips relationship has the correct sign.
Chart 4
It would appear that the Fed is using an incorrect
“model” to forecast consumer price inflation. There was another economist who
had an hypothesis about the cause of consumer price inflation. His hypothesis
was that consumer price inflation is “always and everywhere a monetary phenomenon”.
Of course, that economist was the late (may he rest in peace) Milton Friedman.
So, let’s look at the relationship between a monetary
variable and consumer price inflation. I assume that you are not shocked that
the monetary variable I have chosen to test the Friedman hypothesis is what I
refer to as thin-air credit. I am going to use my “broad” definition of
thin-air credit – the sum of the monetary base (reserves of the depository
institution system and currency in circulation) plus the credit created by the
depository institution system. Commercial banks, S&Ls and credit unions
constitute the depository institution system. The Friedman hypothesis is that
there should be a positive
correlation between growth in the chosen monetary variable and the consumer
price inflation rate.
So, let’s look at the data. Plotted in Chart 5 are the
year-over-year percent changes in quarterly observations of “broad” thin-air
credit and year-over-year percent changes in quarterly observations of PCE
Chain Price Index. The period of observation begins in Q1:1956. The highest
correlation over this sample occurs when growth in “broad” thin-air credit is
advanced by 10 quarters. That positive
correlation has a value of 0.59 – almost three times as large as the highest
positive correlation between the real GDP relative gap and consumer inflation. The
Fed ought to expand its list of suspects to include the behavior of thin-air
credit in order to solve the mystery of recent low consumer price inflation.
Chart 5
To smooth things out a bit, I have plotted in Chart 6
year-over-year percent changes in annual
averages of “broad” thin-air credit and the PCE Chain Price Index from 1953
through 2016. When using annual averages, the highest positive correlation
between the two variables (0.60) occurs when growth in “broad” thin-air credit
is advanced by three years. Suffice it to say, that there is a long lag between
growth in thin-air credit and consumer price inflation. If that sounds
familiar, it was what Milton Friedman observed between money supply growth and
price inflation when he looked at the data years ago. The two series in Chart 6
are plotted contemporaneously (i.e.,
neither series is advanced or retarded) because all I want to do is look for
trend breaks in the data. I can identify three distinct periods of growth in
“broad” thin-air credit – 1953 through 1988, 1994 through 2008 and 2011 through
2016. From 1953 through 1988, the median year-over-year percent change in
“broad” thin-air credit was 8.7%. During the same period, the median
year-over-year percent change in the PCE Chain Price Index was 3.5%. From 1994
through 2008, the median year-over-year percent change in “broad” thin-air
credit slowed to 6.9%. During the same period, the median year-over-year
percent change in the PCE Chain Price Index slowed to 2.1%. From 2011 through
2016, the median year-over-year percent change in “broad” thin-air credit
slowed to 4.5%. During the same period, the median year-over-year percent
change in the PCE Chain Price Index slowed to 1.4%. I see a pattern here. There has been a secular slowing in “broad”
thin-air credit growth accompanied by a secular slowing in consumer inflation.
Chart 6
My data tests (not all included here) have convinced me
that percent changes in “broad” thin-air credit lead percent changes in the PCE Chain Price Index. There has been a
marked slowing in the growth of “broad” thin-air credit since the Great
Recession. There also has been a slowing in the rate of consumer inflation.
Where has all the inflation gone? The way of “broad” thin-air credit. When will
the Fed ever learn?
Paul L. Kasriel
Founder, Econtrarian LLC
Senior Economic and Investment Advisor
1-920-818-0236
