My attention this morning was drawn to the inflation numbers in the January Personal Income and Spending release, specifically the recent downward trend in core PCE inflation:
Coupled with a sizable output gap that yields very high human cost in the form of high rates of labor underutilization - and forecasts that such underutilization will persist for years - would lead one to believe that policymakers still have work left ahead of them. Policymakers, however, do not appear to agree, and instead focus on the fact that output is growing again, even if the 5.9% pace in the final quarter of last year was inflated by inventory correction. Indeed, with the recovery taking hold, there is no imperative for more action. Fiscal policy looks hamstrung by deficit concerns, while monetary policy is poised to turn contractionary as asset purchase programs are wound down. To be sure, few expect the Fed to start raising the Federal Funds rate in the near term. But the Fed is throwing up its hands on unemployment, effectively saying they have done all they can do. Dallas Federal Reserve President Richard Fischer, via the Wall Street Journal:
But the Fed has space to maintain its current policies. “Inflation is not the issue,” given that it is so low right now, Fisher said. “The real issue right now is how patient the people can be, how patient the Congress can be with regard to this slow healing of the employment situation. It’s going to be a slow path.”
True, inflation is not an issue, so there is no rush to tighten policy. But is it too early to dismiss deflation, or at least consider that persistently low inflation demands additional monetary firepower, not less? Fed officials look increasingly poised to dismiss the central deflationary pressure, the cost of housing. This first jumped out in the minutes of the January 2010 FOMC meeting:
One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend.
Is it smart to ignore roughly a quarter of the CPI? Laurel Graefe of the Atlanta Fed responded on macroblog:
However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare.
She concludes:
The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month. Their calculations show a more subdued underlying inflation environment, with median and trimmed mean CPI hovering around 1 percent for the past several months (chart 3). I'm not endorsing this method as a perfect estimation of “true” underlying inflation, but it does provide an example of indiscriminately trimming the outliers to see what's beneath.
Today we learned that Philadelphia President Charles Plosser was likely the dismissive participant:
I’m not as worried about deflation particularly. We’ve had a huge shock in housing. If you look at the components in CPI, a lot of the softness in the CPI is coming from the huge decline in rents and housing prices and housing costs. We want to be careful not to necessarily just count on certain relative prices to keep inflation in line.
Would he be as dismissive if only "certain relative prices" were keeping inflation high? I think not. Is it just Plosser? I found it interesting that Fed Chairman Ben Bernanke drew attention to the price of shelter in his semiannual trek to Capitol Hill:
Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable.
Note that it is not just low inflation that needs to be explained away. From the minutes:
Though participants agreed there was considerable slack in resource utilization, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labor force. If that effect were large--some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession--then the reported unemployment rate might be overstating the amount of slack in resource utilization relative to past periods of high unemployment. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, could reduce the economy's potential output, at least temporarily; historical experience following large adverse financial shocks suggests such an effect. On the other hand, if recent productivity gains were to be sustained, as some business contacts indicated they would be, potential output currently could be higher than standard measures suggested, and the high level of the unemployment rate could be a more accurate indication of slack in resource utilization than usual measures of the output gap.
Some at the FOMC appear ready to dismiss high unemployment rates on the basis that extended unemployment benefits are pulling people into the labor force. But wouldn't that simply be the same thing as saying that we are underestimating underemployment? If we label a person as discouraged rather than unemployed is there really less slack in the economy? It seems that Fed officials actively looking to avoid the inconvenient truth that inflation remains well below target while unemployment remains high even as their attention shifts to weaning the economy from their balance sheet.
Interesting that we should be debating the necessity of raising inflation targets when we can't even get the Fed to direct policy at the target we already have. But I suspect the Fed believes that doing anything more would be the equivalent of raising inflation expectations, a bridge they are not ready to cross. Policymakers are likely to view inflation as a greater concern that the zero bound. David Altig argues a similar point:
To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous....
...my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.
I am not quite so sanguine. While David is correct, the Fed did find ways to maneuver around the zero bound constraint this time, I am more concerned with the next recession than this one. Recent history suggests that each recession necessitates lower interest rates than the last. I would prefer to pull the economy up to a point where we had some distance from the zero bound such that we did not have revert back to managing economic activity via ballooning the balance sheet. And while the balance sheet proved to be an effective tool for defrosting frozen financial markets, would it be as effective if the next time around the problem was simply too little demand in the presence of functioning financial markets? I would rather not endure the experiment.
Moreover, years of watching the Japan experience has left me leery of ignoring the dangers of persistently low inflation. From Bloomberg:
Japan’s consumer prices fell for an 11th month in January, putting renewed pressure on policy makers to eradicate deflation that hampers the recovery.
Prices excluding fresh food slid 1.3 percent from a year earlier, the same pace as December, the statistics bureau said today in Tokyo. The figure matched the median estimate of 29 economists surveyed by Bloomberg News.
Bank of Japan Deputy Governor Hirohide Yamaguchi said this week that prices may not be improving as quickly as he had expected. Finance Minister Naoto Kan today reiterated that the central bank should help the government beat deflation.
An interesting conundrum in Japan. A central bank so afraid of its independence - note the clear pressure from the Ministry of Finance - that it will not aggressively combat deflation, combined with fiscal authorities concerned about the deficit:
Bank of Japan Deputy Governor Hirohide Yamaguchi said yesterday that investors are closely monitoring fiscal policies as “Japan’s fiscal balance is in a very severe state.”
“It’s key that the nation recover its fiscal balance and exercise fiscal discipline,” Yamaguchi told reporters in Kagoshima, southern Japan. “Financial markets are always watching what the government is doing on these fronts.”
The fiscal authorities in Japan need to spend more money, and the monetary authorities need to print more money. One would think an obvious policy solution was at hand.
The US is not Japan. The US has that persistent current account deficit, for example. But we increasingly share some striking similarities. Dual equity and property bubbles. Zero interest rate monetary policy. Deficit concerns. Indeed, I would prefer to take more aggressive action to ensure that we do not share more similarities in the future. But like in Japan, US policymakers have reached the limit of their perceived abilities. Hopefully the similarities will end there.
