Inflation Threat Alert: Blue (Guarded)

Kash Mansori takes a look at recent trends in inflation, but first, a few reminders from our Asset Value Security Department (formerly the Federal Reserve):

Recommended Activities

• All Americans should continue to be vigilant, take notice of their transactions, and report suspicious price increases to local authorities immediately.
• Everyone should establish an inflation preparedness kit and inflation plan for themselves and their family, and stay informed about what to do during an inflation.
• Learn more about preparedness at www.inflationready.gov

The Color-Coded Inflation Threat Level System

This is used to communicate with businesses and the public at-large through a threat-based, color-coded system so that protective measures can be implemented to reduce the likelihood or impact of inflation. Raising the threat condition has economic, physical, and psychological effects on the nation; so, the Inflation Threat Advisory System can place specific geographic regions or industry sectors on a higher alert status than other regions or industries, based on specific information about the threat of nominal price increases.

This system was established in Asset Value Security Presidential Directive 1.

Here's Kash with the threat assessment:

Inflation Update, by Kash Mansori: Some new data on inflation has been released by the government over the past week, including new data on the PPI and the CPI. This gives us a good chance to update our inflation picture.

The chart below shows inflation as measured by the CPI and PPI, including both the measures that capture all goods and services in each category as well as those measures that exclude food and energy prices (the "core" rate).

The rise in energy prices over the past couple of months shows up in the upward movement in the overall price indexes for consumers and businesses. But, unlike some, I am not worried about which way inflation is headed. After a bit of a surge in non-energy inflation during the second half of 2006, those inflation measures have moderated and remain comfortably in the neighborhood of 2%.

While the rate of core inflation doesn't give us a complete picture about how the purchasing power of the dollar is changing, it does tell us a lot about how strong inflation pressures are throughout the non-energy economy. The verdict seems to be that they remain quite moderate.

Comments

[maria]

The US is sitting on an economic fault line. Whenever the Orient and the Gulf get tired of financing our overspending, there will be an earthquake. But as with most earthquakes, you don't know when it will strike. When it does, inflation will be only a tiny part of the problem.

[Wondering about Impartiality]

Using pre Clinton methodology, the CPI today would be measured at about 6%. Using pre 1980 methodology, inflation would be measured at about 10%. Interesting how the changes always result in lower payments by the gov to retirees. Inflation numbers should be measured by someone impartial. Conflict of interest can affect judgment.

[spencer]

In a low inflation world firms tend to raise prices once a year-- typically at the start of the year or the season.

So if you look at the not seasonally adjusted core cpi over half the annual increase now occurs in the first quarter.

This year the first quarter increase in the nsa core cpi was 1.25% versus an average gain of 1.20% over the past decade and 1.28%, 1.45% and 1.38% over the past three years.

This implies that core inflation is neither accelerating or decelerating significantly.

If the Fed is waiting for lower inflation to ease this implies that they probably will remain on hold for the rest of the year. Fed policy is more likely to move in response to changes in real growth then changes in inflation this year.

[bakho]

Isn't the philosophy behind tighter monetary policy as inflation increases to reduce the rate of economic expansion and relieve the upward pressure on wages caused by too low unemployment?

Is this model appropriate if the causitive factor behind the inflation is higher energy prices? In the 1970s high oil prices were attacked by policies that targeted investments in energy conservation and private sector investment in the ability to switch from oil to other sources of energy. Oil consumption dropped by over 20% which caused a deflation in oil prices during th 1980s.

Now that oil consumption in the US has finally passed its 1978 relative high, is it time to revisit those policies that reduce oil usage in order to undercut oil price driven inflation? Does it make sense to instead have a tighter monetary policy that increases unemployment when wages are clearly not driving inflation? Would tighter monetary policy hinder investment in energy conservation technology and therefore contribute to oil price inflation for a longer period?

There is a noticeable increase in food prices that is being driven by higher fuel prices, especially oil. Many of the imputs to agriculture (fertilizer, tractor fuel, chemicals) are oil based.

[Elvis]

1. No comments on how hilariously appropriate the color-coded threat alert is? Activate the funny bone, people.

2. War, high debt levels in both government and personal finance sectors, oil prices increasing. Have we been here before? Do we need to bring out the magic 8-ball?

[ken melvin]

Locally, food and rent are up 15% over one year ago and gasoline is for the desperate only.

[reason]

I wonder about the relevance of inflation indexes when relative prices are changing so much. Has anybody looked into what indexes are appropriate for particular cohorts of people?

[johnchx]

bakho asks: Isn't the philosophy behind tighter monetary policy as inflation increases to reduce the rate of economic expansion and relieve the upward pressure on wages caused by too low unemployment?

Not really.

The first thing to keep in mind is the difference between price changes caused by ordinary supply and demand factors (call them "microeconomic" price changes) and a change in the overall price level, i.e. "macroeconomic" price changes, a.k.a. inflation. Increases in the prices of individual commodities, like energy or labor, driven by the ordinary workings of supply and demand (and, particularly in the case of oil, by fear of uncertainty and cartel behavior, which are also factors in supply and demand) fall into the first category.

Now, there's no obvious a priori reason to expect that the rise in the price of one commodity should lead to increases in the prices of all commodities...quite the opposite. If the price of something my customers buy (from someone else) goes up, my customer has less to spend on what I want to sell him. In all likelihood, I'll have to either (a) lower my price or (b) face reduced sales; in practice, I'll do a little of both.

At least in theory.

In other words, unless something else is at work, the price system should -- mostly, more or less, most of the time -- be flexible enough to communicate changes in relative value without setting off the sort of persistent, economy-wide, and perhaps accelerating price increases that we call inflation.

So, what's the culprit? Basically, money. Inflation -- broad, persistent, economy-wide price increases, or, equivalently, a generalized fall in the real value of money -- happens when a central bank creates (or permits the creation of) too much money too fast. So central banks ought to cut that out.

The trouble, of course, is nobody knows what "too much" or "too fast" actually means, except in hindsight.

The monetarist prescription what that the central bank should ensure that the money supply (measured how, exactly, was never quite settled) should grow at a more or less fixed rate, consistent with the growth of the economy as a whole. It sounds good, but experience in the early 1980's has more or less put this prescription to rest. Few seriously advocate the monetarist position as a guide to policy today.

Related, but different, is the theory that the central bank should set interest rates with the goal of stabilizing the unemployment rate around the "natural" rate (a.k.a. "non-accelerating-inflation rate of unemployment" or NAIRU). The basic idea here is that excess money creation ("loose" money) can temporarily reduce unemployment below the natural rate, but that the long term result will be either (a) a return to the natural rate or (b) accelerating inflation (because the "un-natural" reduction in unemployment can only be sustained by repeated increases in the inflation rate that stay ahead of everyone's expectations.)

In this view of the world, the fall in unemployment below the natural rate is not the cause of inflation, but rather an early symptom of inflation to come. The cause is excessively loose monetary policy.

The problem here again is that nobody knows what the NAIRU actually is at any point in time -- it can change due to things like the existence of Monster.com -- except in hindsight. (Realizing that he didn't know what NAIRU was may have been Alan Greenspan's major contribution to central banking.)

So, we know that we don't want "too much" money, but we've got no way to actually measure what "too much" means. What do we do?

In practice, the Fed resorts to sniffing out inflation itself in the economy, looking at a wide variety of data, more or less systematically but without -- as far as I can tell -- a firm theory in place to specify exactly what the clues mean. (Which is valid -- we don't actually have a firm theory on this, and it's probably better to intentionally flounder about than to impose a theory where no well supported one exists.)

[calmo]

Lovely overlay with the Security Alert Mark. Elvis (1.why does he enumerate, people? 2. are you annoyed yet?) and me think you are the funny boy today...geeze we need it...

Ok, Plonking type II goes to bakho and Plonking type I to johnchx.
Now some of you might think that bakho did not stray from his usual "sensible remarks", but it seems clear to me (who else could I speak for?) john's post pulls it into that category, inviting us to cast the oil externality as not merely an historical (and therefore so sensible) artifact but a theoretical construct for our stupefication.
That would leave Mark's funny business as the "sensible" remark (to wit: the dangers of inflation are somewhat inflated)...not the Plonking type II that only Elvis feels obliged to identify (to more wit: the dangers of inflation are hilariously inflated).

[Wanniski Reject]

"(Which is valid -- we don't actually have a firm theory on this, and it's probably better to intentionally flounder about than to impose a theory where no well supported one exists.)"

Since Mr. Jett is nowhere in sight, I'll add that the POG is used by some people (including the Fed) as one of the indicators. Empirically it does seem to work rather well though as I've stated before, there currently should be a natural increase of about 3% per year above inflation as long as people find it to be a monetary asset rather than just another commodity.

I do remember Bernanke explaining what he does all day and that included looking at a constant stream of data including the gold market.

"Moving to specific discussions of inflation, while Bernanke at one point retreated into output-gap orthodoxy that says inflation results when “aggregate demand, aggregate spending is greater than even the growth that underlying conditions can permit,” he also specifically referred to gold as one indicator that he’ll use in gauging inflation pressures. Anecdotally, Bernanke has reached out to various economists who believe monetary policy would be more effective if the dollar were defined in terms of gold or a basket of commodities.

While the above is clearly a positive, Bernanke added that his inflation strategy will be “very eclectic,” and he’ll “look at a wide range of indicators.” Alan Greenspan has done the same thing, and as Steve Forbes noted recently, “Greenspan’s gut has not been infallible.”

http://www.nationalreview.com/nrof_comment/tamny200511220831.asp

And this honestly funny but accurate parody from Mish,

That we are frightened by so many things is clearly visible in the price of gold. In fact, we really have been trying to figure out why the price of gold isn't much higher given how frightened we are. This is indeed our latest conundrum...

Make no mistake about it, a recession is where we are headed. We admit our role in fueling these bubbles by holding interest rates too low too long. Rather that attempt to cover up past mistakes our new policy at the Fed is honesty, and honestly we really do not know what to do. When we do decide what to do, we will tip off the banks first (just as we always have) because our biggest fear of all is a collapse of the banking system.

Ben Bernanke

http://globaleconomicanalysis.blogspot.com/2006/12/email-from-bernanke.html

[jamzo]

reading the word inflation and the phrase Asset Value Security Department (formerly the Federal Reserve)in the same paragraph caused me to think about the real-estate bubble and the increase in value of housing

[Is This Wise]

The computer I bought most recently has more RAM than the previous model, but cost the same. Does it really help the average citizen for the fed to raise the price of essentials like food to compensate for improvements in computer technology?

[cm]

The humorous point of the color indicator has been made (whether blue is the appropriate setting I'm not going to discuss), but otherwise its name is grossly misleading -- the concept of "threat level", whatever its merits, is designed for expected impending and (presumably) singular events. Is inflation in anybody's opinion of the nature that it happens on particular days, or "we expect it to happen this week with likelihood X"?

[EZRider]

"Using pre Clinton methodology, the CPI today would be measured at about 6%. Using pre 1980 methodology, inflation would be measured at about 10%. Interesting how the changes always result in lower payments by the gov to retirees. Inflation numbers should be measured by someone impartial. Conflict of interest can affect judgment."

This kinda goes along with the philosophy of people in the Federal Government (and lately economists who work for the Federal Government), Ignore what you don't like.

[cm]

johnchx, bakho: Prices (if unregulated) are only quite indirectly driven by input costs, and primarily by "what the market bears". If (substantial) overstock has to go (e.g it's perishable or subject to obsolescence), and won't move at no or small discount, vendors will not hesitate for long to sell even at a loss. Input costs will only "drive" prices to the extent that proposed price increases will pass because everybody has to raise, and aggregate demand doesn't drop substantially (nor is expected to).

For price increases to pass without a compensating drop in demand, customers have to cut other spending, or must have a source of funds from either diminishing capital stock, income, or loans, "new money" being a major source of creating or replenishing the latter.

[calmo]

I see cm is fascinated with the signage.
And I need to encapsulate the Threat Level Warning System Implementation apparatus (the sign, like the one on your front lawn "You Will Read Anything")
[Ok, that wasn't it: "Keep off the Grass"]Beware that Moment of Inattention It distracts you for atleast one of those moments...well for some of us (I speak personally)...hours...could be days...the way it's going. It was a direct lift from the Forrest Fire Rating Boards, no? (I can just see the terrorists out there monkeying with the pointer to get a LOW reading to put us off guard.) But there is no seasonal expectations. We can't tell if the sign is really up to date based on previous experience. The HIGH reading might only be the terrorists on coffee break insisting we pay real close attention just to wear us down. (Are you still payin attention?)
Ok, I need a break, but the message is: the signs are way silly...and the Fed is too about The Dangers of Incipient Inflation...who can I enlist for support? (great signage?) :JG on that plonking thread). Don't be out-plonked by mere professionals.

[save_the_rustbelt]

My wife, who will squeeze a nickel until the buffalo screams just went grocery shopping this morning, came home
and announced that everything is going up.

I give her views great credibility, so maybe we have a problem.

[calmo]

"screaming buffalos"...duly noted. Your wife is well-connected I see...so when those (squished) nickels run out, she has a backup literary phenomena she can unleash on the world.
My regards to her fine taste in husbands.

[Cassandra]

johnchx's discussion is, as always spot-on. As are all the poster's frustrations with current index measure (or more accurately mis-measures) that serve to obfuscate and constrain purposeful price-level indicators.

The ECB v. FRB debate over whether the central bank must wait see the "whites of the inflationary eyes" before acting rather than flagging a potential threat by observing M3, asset prices etc. remains crucial to any analysis. And like the Sufi parable about the blind men and the elephant, arguing about what is was after each groped a different part of the animal, so inflation must be assessed with all tools and powers of observation. This is particularly true in the current epoch where capital flows freely, banks are multinational, securitization and financial technology make monetary and credit creation incredibly facile, and difficult to measure precisely at any point-in-time. One needn't be a rocket-scientist to simply look at the last page of the Economist and see the magnitude of aggregate accumulated reserves (mostly USDs) and aggregate deficits to understand the inflation potential from the the USA's cumulative binge. Waiting to see it in the price of an hedonistically-adjusted loaf of Wonder-Bread seems decidedly imprudent

There are many analogies to current US attitude towards fiscal and monetary policy vis-a-vis the truly massive bubble in liquidity itself, but I like the one of the bathtub that's overflowing with spigot still running in an upstairs apartment. Even though the water hasn't copiously leaked downstairs, it's pretty deterministic that it's not the neighbors upstairs that under imminent threat .

[calmo]

Sheesh --talk about hitting the homerun after hoursEven though the water hasn't copiously leaked downstairs, it's pretty deterministic that it's not the neighbors upstairs that [are] under imminent threat So where were you when the going was tuff with the trickle downers, Cass? [Out plonking, spreading rumors of how water can be made to run uphill maybe?]
US Inflation is a measure of consumption --that CPI basket of goods --not stocks, commodities, nor your house (importantly OER instead): not the possessions of the wealthy. Not wages (neither those Texas janitors nor those ~$100M yearly heists of hedge fund managers cited by anne). It is not about the wealthy, is my discovery (thanks to wally at CR) but about their servers and whether they need a little more encouragement or less.
The Europeans have a larger view: not so insistent upon looking at members of the economy solely as consumers but as agents who use the currency for other purposes as well.
More could be said about these 2 views and measures of inflation...just not by me at this plonk-free moment. Dang.

[bakho]

My point is that our economy needs to address our energy usage far more than we need more effective inflation targeting.

What cm says is true, absent a wage-price spiral. Tightening credit does reduce demand, but the demand reduction also creates unemployment that holds wages down. In one view, it was the high unemployment accompanying the tight monetary policy of the early 80s that broke the wage-price spiral. Since that time a combination of mechanization, offshoring and anti-union legislation have created a climate where the wage portion of the wage-price spiral has little upward pressure.

Concurrent with the reduction in wage pressure was the breaking of the oil cartel (and high energy prices) through increased efficiency by the mid 1980s. The Core PPI is currently at zero, while Total PPI is a reflection of energy cost increases (Finished energy is 3.6%). While there are some profits being squeezed, a substantial portion of the energy costs are being passed on (food costs currently at 1.4%). Some input costs are not readily passed on, but energy is not one of them. A wage-price spiral would move toward adjusting energy costs downward relative to other costs. Because energy prices will never be "caught" the wage-price spiral continues.

The economic adjustment for energy relative to other prices is to greatly reduce energy demand, reducing the price. In the 1970s, the baffling wage-price spiral was difficult to stop as long as the energy issue was not addressed,. After the energy issues were addressed in the mid to late 1970s and consumption reached a valley in the mid 1980s, wage-price spirals suddenly disappeared.

This is not to say that monetary policy is not important. However, monetary policy works best within narrow economic limits and oil price shocks typically exceed the limits of effective monetary policy. When factors influence the economy in new and large ways, it is useful to take a more holistic view especially with regard to policy. The same old monetary and fiscal levers are not necessarily the best tools for dealing with a new problem.

Inflation often acccompanies scarcity of essential commodities. If you cannot successfully address the underlying scarcity, then it is more difficult to hold inflation in check.

[cm]

save_the_rustbelt: Prices have always slowly crept up in the "brand name" one-stop-shop places like Safeway, but my perception is that this calendar year, perhaps even in late 2006, there has been a noticeable acceleration. Even "sale" prices seem to have gone up noticeably. That for domestic as well as imported stuff.

[cm]

bakho: Thanks for responding. One thing I originally intended to add but which I forgot was that while input costs do not (directly) drive prices, they do drive the decision whether to continue producing the good/service in question, or whether to modify either the production process, the definition of the product, or unit sizes, which may have an effect on supply and quality.

These days it looks like the increased prices are still being paid. With the generally applicable caveat that detailed and credible numbers are hard to come by, I'm of the opinion that things definitely point to increased (perhaps just sustained?) aggregate money supply through the recent credit binge, combined with forex-accomodated price cuts on imported discretionary items (many manufactured consumer product categories).

[cm]

Example for price cuts -- USB memory sticks. Sometime last year (Sep/Oct?) I bought a 1 GB stick on sale for $18, nominal price then $30 (if memory serves). In December, I bought another 2 GB stick on sale at $30, the then still "regular" price of the 1 GB part (as a gift for somebody else, I'm still happy enough with my old part). Today I saw an ad in the paper for $8 for the 1 GB stick that I purchased for $18 just half a year ago that was then $30 reg.

No wonder our inflation is "mild". If only I could replace my daily staples with a daily memory stick or CD-recordable.

Caveat: I'm sure one can get all of that even cheaper by internet-order. I'm old-fashioned and go to a store where I can hold the merchandise in my hand.

[Is This Wise]

This brings out the changing nature of the CPI. Originally, it was designed by Woodrow Wilson to track mostly essentials necessary for life. Now it tracks quite a number of items that are not essential for life (memory sticks). Since non essentials can easily be cut back on if things get tight, deflation or improvements in non essentials does not really offset the rapidly rising prices of essentials. Essentials cannot easily be reduced or eliminated, so the rise in the cost of essentials can easily be much higher than the CPI.

A CPI that measured only essentials like Woodrow Wilson did would be much higher than today's core CPI. This accounts for many people who live close to the edge complaining that their personal rate of inflation is much higher than the CPI.

[cm]

Is This Wise: What is practically a necessity also changes over time. It does not stop at food and shelter, but there are a number of items needed beyond those conveying subsistence to participate adequately in society. For example, Adam Smith's "clean linen shirt" in his days.

Today you may as well include cell phones. When I'm on the road, I could hardly make phone calls these days, other than begging store operators to let me use their phone or spending hours hunting for a pay phone. I don't have a cell phone, and fortunately I don't generally have the need to make calls when outside. Let's say 10 years ago you would have to search for pay phones too, but you would quickly find one. Today you will find the cabin, but the phone has been uninstalled.

This doesn't invalidate your point of course, there are still many items in the CPI where their being part of social necessities is at least questionable.

[cm]

Never mind that at the pay phones that still exist, a simple local call costs 50c.