Tuesday, March 31, 2015

Inflation Remains Below Target (excerpt)

So what is inflation doing? February’s inflation data released in yesterday’s personal income report show that the core PCED remains stuck about half a point below the Fed’s 2% target for this variable. It was up 1.4% y/y during February, and has been hovering around 1.5% for the past 10 months. However, over the past three months through February, the core PCED increased 0.9% (saar), the third consecutive reading below 1.0%. It may be hard for Fed officials to be reasonably confident that inflation is heading higher given the trend of the recent three-month inflation rates.

The persistence of the core inflation rate below 2% despite ultra-easy monetary policy in the US and elsewhere over the past six years is certainly puzzling Fed officials. Nevertheless, rather than reassessing their models of inflation, they continue to expect that a tightening labor market will boost wage inflation soon, which then will boost price inflation. In other words, they continue to bet on the Phillips Curve model.

I have argued on many occasions over the past couple of years that there may be structural forces at work (such as globalization, competition, and innovation) keeping a lid on inflation. If so, then maintaining ultra-easy monetary policy to boost wage and price inflation may instead boost asset inflation. Indeed, easy money actually may be deflationary by boosting supplies of goods and services more than the demand for them, as I’ve discussed before. Let’s have a closer look at the latest price inflation data:

(1) Inflating, disinflation, & deflating. The PCED is based on prices in the CPI, but with different weights that are more reflective of actual consumer spending. The core CPI inflation rate tends to exceed the core PCED inflation rate. The former was 1.7% y/y during February, while the latter was 1.4%.

The services components of the CPI and PCED rose 2.4% and 2.1% during February. Both have disinflated by about 50bps since early 2014. Nondurable goods prices including energy are deflating--down by about 4% y/y. Durable goods prices are also deflating--down 1.6% in the CPI and down 2.6% in the PCED.

(2) Devil in the details. One of the main reasons why services inflation is lower in the PCED than in the CPI is because medical care services inflation is lower in the former (currently 0.8%) than in the latter (currently 1.8%). Both have been disinflating in recent years. It’s not obvious to us why the Fed would want to see this component of inflation rise to achieve its 2% target.

On the other hand, rents have been rapidly inflating in recent years based on the CPI (3.5%) and PCED (3.4%), with both at the highest readings since November 2008. Again, would Fed officials cheer if they achieved their 2% inflation target by driving rent inflation still higher?

It’s not obvious how ultra-easy monetary policy is supposed to stop consumer durables prices from deflating. They’ve been doing so mostly as a result of globalization, which has lowered labor costs in manufacturing. Now automation and robotics is increasingly replacing labor in durable goods manufacturing. If the Fed’s policies succeed in boosting wage costs, manufacturers may simply replace labor with technology. This all begs the question: Why are higher durable goods prices a good thing anyway?

Today's Morning Briefing: Days of Wine & Rosés. (1) Les Misérables. (2) Rosé a day. (3) Setback for Socialists in France. (4) Six cylinders firing in Eurozone. (5) Slicing and dicing Yellen’s latest speech. (6) FOMC lowers new normal unemployment rate. (7) Waiting for Godot and Phillips? (8) From ZIRP to LIRP. (9) Liftoff coming, though it might be postponed, but will be gradual until further notice. (10) Fed puzzled by persistence of low inflation. (11) Slicing and dicing the inflation data. (12) Three-month annualized core PCED inflation rate falling below 1.0% rather than rising to 2.0%! (More for subscribers.)

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