Greg Ip

Articles by The Economist’s U.S. Economics Editor

The spontaneous combustion theory of inflation

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Jun 26th 2014, 15:42 by G.I. | WASHINGTON, D.C.

In the last few weeks, ominous warnings of inflation’s imminent resurgence have multiplied, prompted by recent upside surprises on core inflation and the cavalier dismissal by Janet Yellen, the Fed chair, of those reports as “noise. “
On factual, theoretical and strategic grounds, I find the panic over inflation perplexing.
First, factual. Yes, core CPI inflation has rebounded to 2% from 1.6% in February and today we learned that core PCE inflation has risen to 1.5% from 1.1%. What should we infer from this? Nothing. In the short run inflation oscillates because of idiosyncratic movements in various components, such as rent, health care and imported commodities, but over longer periods, it is remarkably inertial: the best forecast of inflation over the next five years is inflation over the past five years. The nearby chart illustrates this;

core inflation fell below 1% in 2010 and rose above 2% in 2012; neither marked the start of a new trend. There is no reason to think the recent run of high monthly readings is a new trend, either. The Fed, to its credit, didn’t freak out when core inflation was scraping 1% earlier this year; it predicted that as the downward pressure from imported goods inflation and health care faded, overall inflation would move toward its 2% target, and it has. Yes, it has done so slightly faster than expected but this is no more cause for concern than learning a patient will be discharged from the intensive care unit in six weeks instead of eight. Second, theoretical.  If you have a forecast of higher inflation, it helps to have a theory of the inflation determination process behind it. Inflation is a continuous rise in the price level; the obersvation that the price level has risen recently is not a theory any more than a patient’s high temperature is a theory of infectious disease. Many critics think the prolonged period of low real rates and the large size of the Fed’s balance sheet are in and of themselves inflationary, but this is divorced from any consideration for why real rates are negative and the Fed’s balance sheet so large in the first place. Charlie Evans, president of the Federal Reserve Bank of Chicago, calls this “the spontaneous combustion theory of inflation… Households and businesses simply wake up one day and expect higher inflation is coming without any further improvement in economic fundamentals.”
There are many competing theories for the inflation determination process. What do they tell us?  The New Keynesian theory, to which the Fed subscribes, considers inflation a function of slack and expectations. The evidence is pretty persuasive that while slack has shrunk in the last five years (and perhaps faster than expected because of diminished potential), it remains ample. Expectations, likewise, have oscillated but shown no trend up or down.
You may dismiss this model because slack is hard to measure and expectations are a lagging indicator. Perhaps you prefer to look at costs (as a mechanical price mark-up model does). Labour is the main component of costs, and as the nearby chart shows,

unit labour costs are up just 1.2% in the last year. This, too, is a noisy series, as it is driven by both wages and output per hour; but it’s hard to see a worrisome trend. Wages have barely kept up with prices since the recovery began which means the benefits of productivity growth (meager though they are) have gone predominantly to profit margins, which touched a new high of 12.7% in the fourth quarter. They dipped in the first quarter, but they’ll probably bounce back after GDP reverses its drop. So profit margins could accommodate some acceleration in labour costs and remain comfortably wide. What if you consider inflation always and everywhere a monetary phenomenon? I consider the money supply pretty useless for forecasting anything, but even if were a monetarist, I wouldn’t be worried. Quantitative easing has significantly expanded the monetary base, but that expansion will end once QE stops later this year. Meanwhile, this has not fueled broader measures of money and credit: M2 is up just 6.5% in the last year, slightly faster than last year but still well below rates of growth recorded in 2011 and 2012 (which, you’ll recall, did not signal an inflation breakout).

Third, strategic. I recently attended a conference at the Hoover Institution on central banking where many of the presenting scholars were deeply concerned the Federal Reserve’s unorthodox policies would lead to an eruption of inflation before long. Many cited the 1970s when the Fed kept real interest rates too low for too long in the mistaken belief the economy was operating below potential. What these analyses ignore is the asymmetry of risks facing the economy. Of course, the Fed might wait too long to tighten and inflation could eventually rise above the 2% target. But, leaving aside how costly such a deviation would be, the Fed has demonstrated it knows how to get inflation back down, even if the process can be costly. By contrast, recent history shows how few effective tools central banks have for reversing inflation that falls too far, or turns to deflation. Either outcome raises the prospect of real interest rates that are too high and unemployment above its natural rate for years to come. Given this asymmetry, overshooting inflation is clearly a lesser evil than undershooting inflation. This, more than anything else, is why the panic over inflation is misplaced.


Written by gregip

June 26, 2014 at 5:25 pm

Posted in Blog posts

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