Wednesday, July 16, 2008
The Federal Reserve Bank of Boston (left building) is a great building. Notice how it towers over the main train station in Boston, South Station (immediate right of the Fed building). This picture represents monetary policy in the United States.
The latest economic data has been quite dreary. June’s employment report showed 62,000 in job loss, retail sales slumped to 0.1% growth, where higher gasoline prices were the only reason that it was positive at all, and overall economic growth came in at just 1% in the first quarter. It seems like everybody is calling a U.S. recession!
Today, the June inflation report was released. Headline inflation (the rate at which measured prices at the Bureau of Labor Statistics change) is up 1.1% over the month, and that is its highest level since 2005. Energy prices rose another 6.6% over the month, and food prices jumped 0.8%. If you are like the Fed and place a lot of stock in core inflation (headline inflation minus food and energy inflation), it rose 0.3% over the month. All in all it sounds quite gloomy, especially for the U.S. central bank, the Federal Reserve Bank. Why? Because weak economic growth + inflation = Fed nightmare.
The Fed’s goal
Inflation was already on the Fed’s radar. Yesterday, the Federal Reserve Chairman, Ben Bernanke, testified to Congress:
“Given the high degree of uncertainty, monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.”
In short: as people begin to expect higher prices (longer-term inflation expectations), there is a risk that firms will pass on some of the recent surge in energy costs to the prices of their goods and the wages they pay workers. In the end, all prices will start to rise.
The Fed, an academic institution, tends to focus it policy efforts on core inflation. Food and energy prices tend to be quite volatile, moving up and down very quickly, and distract from the overall price trends (up or down) of all other prices.
Is the Fed correct in targeting core inflation?
Many believe that the Fed’s objective of stabilizing core, rather than headline inflation (all prices, including food and energy), is misguided. First, core inflation is actually more volatile than alternative measures of inflation. A recent study shows that a measure of inflation that excludes just energy is more stable than the “core” measure that the Fed relies on; it is that measure of inflation that should be followed.
Second, others argue that ignoring food and energy is simply misleading. Energy prices increased 6.6% in June, and are bound to result in higher prices of all goods; it is a foregone conclusion.
It is difficult for me to think that firms are acting irrationally and not passing on energy prices for any reason except that it is not profitable to do so. The U.S. economy is struggling, and if firms raised prices, they would likely lose more customers than they would gain in the price increase. Profits would fall. Thus, it is not a foregone conclusion that food and energy inflation will reach other prices (core) unless it becomes profitable.
Here brings us to inflation expectations, which are important to the Fed and its policy decisions than any measure of current inflation. If consumer expectations over inflation were to rise, then it can be argued that consumers would then be more apt to pay higher prices. Therefore, if firms raise prices as expectations are rising, then they would not lose as many customers, and profit loss would be less than if expectations were well anchored. It does not matter whether the Fed is monitoring core or headline inflation if expectation adjustments are the only mechanism by which prices start to rise in the long run.
I believe that the energy and food price inflation will fall, and that the two measures of inflation, headline and core, will converge. However, in the near-term, consumers are strapped for cash when the price of gas rises 11% in June. So, what should the Fed do? Should it promote maximum sustainable growth (which is surely greater than the anemic 1% in the first quarter), or should it insure price stability (make sure that inflation is stable)?
Now it certainly does matter whether the Fed is looking at core inflation, which has remained quite stable in the 2-2.4% range over the year, or headline inflation, which recently hit its highest level since 1991 at 5.2%?
In my opinion, it should focus on core inflation. As long as energy and food prices are expected to recede back to some long-run level, then headline inflation will fall, too. Remember, inflation is a % change in prices, so as long as energy prices are not rising continuously, then inflation will not accelerate, inflation expectations remain in check, and core prices remain stable. Core is a better measure.
Outlook on energy prices
This all hinges on the fact that energy prices will recede (probably not back to where they were a year ago, but at least stop growing).
Most economists agree that Emerging market growth and tight oil supplies are the primary culprits of the recent surges in energy prices. According to Ben Bernanke, “Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets.”
Emerging markets (including China, Brazil, India, Indonesia, Russia, Taiwan, etc) are not expected to slow significantly and oil supplies are expected to remain tight. According to the IMF, emerging market growth is projected to remain strong through 2009 (6.6%). Further, oil supplies from key economies (Saudi Arabia, Venezuela, Canada) are not expected to expand significantly through 2013. It looks like strong demand and tight oil supplies are here to stay.
As of July 8 and based on measures of supply and demand only, the Energy Information Association forecasts that the annual average price of oil will be $127/barrel in 2008 and $133/barrel in 2009. That is high, but no higher than where the price sits today ($134/barrel on July 16th). As long as oil prices are high and not rising further, the inflation problem will go away.
Point: the increase in the price of oil, and thus energy, is expected to halt and inflationary pressures will fall.
As long as the Fed is targeting a measure of inflation that is based on stable inflation expectations, it doesn’t really matter if that measure is core or headline inflation. Further, by targeting headline inflation and energy inflation surges, the Fed may overcompensate. It would start taking money out of the economy too soon in order to control inflation, resulting in a guaranteed recession.
I am with the Fed on this one: as long as inflation expectations are reasonably anchored, actions countering inflation are a too extreme given the tenuous health of the U.S. economy.
A final note
As a final note, it occurs to me that there is no universal “best measure” of overall price adjustments. In the 1970’s, headline inflation was well above core inflation; in the 1980’s, core inflation exceeded headline inflation; in the 1990’s, both measures of inflation were stable and in line with each other; in the 2000’s, headline inflation is well above core inflation. High energy prices are likely here to stay, but are unlikely to keep growing so quickly. So, the Fed should remain cautious, but not act too quickly to tame inflation.
I am very interested to hear your comments. Please leave them below. Best, Nontruths