The core consumer price index (CPI) rose by 0.2% in July. The chain-weighted core CPI did not rise at all, following two months of 0.1% gains. Yet the fixed-weight version seemed to speed up when compared with last year. Why? Because in 2005 the comparable monthly gains averaged just 0.13 from April through September (a 1.6% annual rate). If the increase is the same 0.2% in August, the year-to-year increase will nonetheless appear to rise from 2.7% to 2.8%, because last year’s numbers were so low.
Such misleading percentages are just one reason some economists argue the Federal Reserve has not yet done nearly enough to contain core inflation. Last week’s column dealt with another reason — unit labor costs. But there are so many others that the only way to explain why I find these arguments unpersuasive is to go through them one by one.
The case for much more aggressive Fed tightening was carefully articulated in a Wall Street Journal piece by Mike Darda, chief economist at MKM Partners. He proposes "hiking the fed funds rate to 6% with more hikes to follow."
"The strongest case against the Fed’s decision to pause," he wrote, "was presented by several forward-looking price-level indicators. … Gold prices have risen to $135 an ounce on the year, while the dollar has fallen 6% against G-6 currencies and inflation-linked bond spreads have widened by 33 basis points." Do those variables predict inflation?
First, gold: The price of gold rose from $272 in August 2001 to $725 in May, before dropping back to $623 lately. If rising gold prices predict inflation, why have we not already seen much higher inflation?
The most astonishing increase in the price of gold — from $239 in April 1979 to $850 on Jan. 21, 1980 — was a reflection of current inflation. The CPI excluding energy rose by 11.3 percent from December 1978 to December 1979.
In a February paper for MKM Partners, Darda theorized that only increases above about $475 predict future inflation. His graph shows that gold exceeded $475 in February 1983 ($491), yet inflation fell dramatically after that. Gold next peaked at $500 in December 1987, and Darda therefore compares the latest "gold-price breakout" to 1987, which "foreshadowed more than three years of rising core inflation." During those three years, however, the price of gold fell. Gold was down to $271 in 1999 and $279 in 2000. Yet cheap gold then foreshadowed rising core inflation in 2000 and 2001.
Second, the dollar: "The dollar has fallen 6 percent against G-6 currencies," says Darda. That same index fell 44% from March 1985 to April 1995 — from 143.9 to 80.3 — which was deflationary for Japan but not especially inflationary for the United States. The dollar climbed with the 2001 recession, but was back to 80.1 in December 2004, 80.9 in March 2005 and 82.1 this July. The July figure was up 1.5 percent from March 2005, yet down 4.5% from July 2005. Unlike 1985-1995, there is no clear "weakening trend." The dollar matters to the extent that it affects import prices. Aside from oil, import prices were up just 2.3% for the year ending in July.
Third, the TIPS spread: Darda said, "Inflation-linked bond spreads have widened by 33 basis points," but did not say when. The yield on 5-year inflation-protected notes fell 36 basis points from June 28 to Aug. 15. The spread between yields on 10-year bonds and inflation-protected bonds has hovered around 260 basis points (2.6 percentage points) since May. That offers a clue about expected inflation over 10 years, but not one or two years. Frank Schmid of the St. Louis Fed found the spread overreacts to gyrations in Fed policy. In any case, regular 10-year bonds are being snapped-up with a 5 percent interest rate, even lower than the fed funds rate. It makes no sense to suggest the gold market is omniscient (until May) but the bond market is foolhardy. All markets share the same information.
Darda worries that "unit prices have been advancing at just over a 3% pace." But that deflator for non-farm business includes energy costs paid by businesses — it is not a measure of non-energy prices facing consumers. He added some other concerns:
Fourth, velocity: "Monetary velocity, the torque behind the money stock, is growing at an above-average trend," according to Darda. This is just an odd way of saying the money supply has been growing very slowly. The change in velocity equals the change in the money stock minus the change in nominal GDP (total spending). Darda favors a very broad measure of money called MZM, the growth of which slowed from 15.9% in 2001 to 7.4% in 2003 and 2.1% in 2005. To describe such a dramatic slowdown in money growth as inflationary is inexplicable.
Fifth, real interest rates: Darda says, "The Fed was running an extremely tight monetary policy in late 2000, with the real fed funds rate rising 5 percentage points above core inflation." In the fourth quarter of 2000, core inflation was only 1.5% "at an annual rate." On that dubious basis, however core inflation was 4% in the first quarter of 2000, which would make the real fed funds rate seem half as high as he said.
Subtracting even an exaggerated core figure such as 2.7% from the current fed funds rate leaves a real rate near 2.6%. It was briefly higher during recessions of 1990 and 2000 (3.5%), but not for long. Martin Feldstein recently advised the Fed to "take the risk of tightening too much." Soon after the Fed does that, however, it ends up easing too much — as in 1992-1993 and 2003-2004.
Those who deploy statistics to describe current Fed policy as inflationary are usually comparing the fed funds rate to measures that include energy prices — such as nominal GDP, the non-financial business deflator or the total (not core) CPI. Such comparisons make sense only if the Fed should raise interest rates whenever oil prices are increased by hurricanes or Mideast conflict, and then reduce interest rates when oil prices fall.
Those of us who do not believe that monetary policy should fluctuate with energy prices simply do not agree. All that extraneous chatter about rising velocity or whatever is just an unhelpful distraction.
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