Wednesday, March 19, 2014

Is Easy Money Deflationary? (excerpt)

There’s not much inflation in OECD consumer price indexes. The CPI inflation rate for this group of 34 advanced economies was just 1.6% y/y in January. It’s been hovering in a 1.0%-2.0% range since the start of 2010. The Eurozone’s CPI inflation rate is especially low at 0.7% during February.

In the US, the CPI inflation rate was just 1.1% last month. The core rate (excluding food and energy) was higher at 1.6%. However, that’s the lowest since June 2013's two-year low, and the twelfth month in a row of readings below 2.0%. Why does inflation remain so low despite the recovery of the global economy over the past several years?

Keynesian economists believe there is too much slack in the US economy and other economies as well. They believe that fiscal and monetary policies must stimulate more demand. I’ve argued that there may simply be too much competition in global markets. That implies that there may be too much supply as producers have had ample availability of cheap credit to expand capacity and to use new technologies to increase productivity. While most macroeconomists believe that easy money is always inflationary, it hasn’t proven to be so in recent years. Hence, my contrarian view that easy money can be deflationary by enabling the expansion of supply.

Technological innovation also tends to boost supplies by boosting productivity. In the past, rising productivity lifted the real purchasing power of workers. As they spent more, employment would also increase. In recent years, there seems to be a widening divergence between productivity and both real compensation and employment.

The result of these divergences may be an excess supply of labor. In a competitive labor market, wages would fall and eliminate the excess supply. However, governments tend to intervene by raising minimum wages and by providing welfare benefits to the unemployed. So people drop out of the labor force. Wages don’t rise much because productivity is always increasing as technological innovations allow more to be produced with fewer workers.

Previously, I demonstrated that the resource utilization rate--a measure of economic slack derived by averaging the capacity utilization rate and the employment rate--has a very low correlation with the CPI inflation rate. There’s a much better fit between this inflation rate and unit labor costs--hourly compensation divided by productivity.

Today's Morning Briefing: Widening Divergence. (1) S&P 500 going boldly. (2) Not going according to bears’ script. (3) YRI Global Growth Barometer flat-lining. (4) Commodities and emerging markets underperforming. (5) Fundamental Stock Market Indicator diverging less with S&P 500. (6) Not much inflation in OECD’s advanced economies. (7) Not enough demand or too much supply? (8) Might easy money be deflationary rather than inflationary? (9) Productivity is outpacing real pay. (10) Excess supply of labor? (11) Unit labor costs driving inflation. (12) Focus on overweight-rated S&P 500 housing-related industries. (More for subscribers.)

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