-- David M Gordon / The Deipnosophist
Bernanke's testimony yesterday revealed that although the Fed believes that inflation pressures are going to diminish, they remain on guard since it will be several months at least before they can be sure that inflation has turned the corner. The core PCE deflator has been above the Fed's 2% target for two and a half years, and continued complacency could weaken the market's faith that the Fed will keep inflation under control.
In the Fed's view, inflation pressures increase if the economy grows above its "potential," and decrease if the economy slows down. The fact that growth in the last 9 months of 2006 slowed to a roughly 2.2% pace (taking into consideration that Q4 GDP growth will likely be revised down from the originally reported 3.5% to 2% or so due to adverse news on net exports and inventories) is thus a source of comfort to the Fed. But the labor market remains "tight," with low unemployment, rising wage gains, and no sign of any increase in the pace of layoffs. With productivity having fallen, the Fed's estimate of potential growth has also fallen, which means that the economy will likely have to grow at a sub-3% pace to avoid triggering greater inflation concerns among Fed governors. The housing market is likely to be a drag on growth for most of this year, and if that keeps the economy growing at the pace of the past nine months then perhaps the Fed can breath a sigh of relief as it will have executed a nice soft landing and no further action on the interest rate front will be required. For the time being, the Fed is likely to remain on hold.
For more than 10 years I have used a different model of inflation, one based on an analysis of sensitive market indicators of inflationary pressures. This model assumes that inflation is a monetary phenomenon, not a byproduct of excessive growth. Inflation results from an excess of money relative to the demand for money, and this imbalance can be observed in a variety of key indicators. Signs of easy money and rising inflation pressures include 1) a weak dollar, 2) rising tangible asset prices (gold, commodities, and real estate), 3) low credit spreads, 4) low real interest rates, 5) a steep yield curve, and 6) rising breakeven spreads on TIPS.
After consistently forecasting low and falling inflation throughout the 1990s and early 2000s, I switched to a forecast of rising inflation in early 2004. At the time I made this call, the dollar had declined 30% from its early-2002 high, gold had risen from a low of $250 to over $400, real estate and commodity prices were rising everywhere, credit spreads were low (swap spreads were less than 40 bps), real interest rates were relatively low, the yield curve was steep (2-30 spreads were over 300 bps), and breakeven spreads had risen from a low of 1.2% to 2.3%. In short, all the key indicators suggested that monetary policy was accommodative, and the Fed also told us so, promising to keep the Fed funds rate at 1% "an extended period". I thought that the Fed had been too easy for too long, ignoring all the signs that liquidity was abundant and the economy was accelerating, and that this pointed clearly to a rising inflation trend over the next several years.
As it turned out, the core PCE deflator bottomed at 1.1% in Sep. '03, and the core CPI registered a low of 1.1% in Nov. '03. Both measures subsequently rose to 2.5% or so, briefly touching 3%. That's not much of an acceleration, and to be honest it was a good deal less than I expected to see, but the trend was indeed up. Interest rates have also trended up (albeit very gradually) since then, and the Fed ended up raising the funds rate somewhat more than the market expected.
Surveying the inflation landscape today, the first four of my key inflation indicators suggest that monetary policy is still accommodative: the dollar is quite weak, gold is strong, industrial commodity prices are very strong, spreads are low, and real interest rates are relatively low. Real estate prices are soft on the margin, but remain quite elevated. The last two suggest that monetary policy is just about right or maybe a bit tight: the yield curve is partially inverted, and breakeven spreads are low and stable. So as I read the monetary tealeaves, I conclude that the current outlook for inflation is mixed, but the balance of risks points to a modest uptrend in inflation over the course of the next few years, and gold at $670 is giving the strongest such signal. The fact that gold rose and the dollar weakened in response to Bernanke's testimony supports the view that keeping policy on hold equates to remaining somewhat accommodative.
As Bernanke indicated, of course, it's going to be at least several months before we know whether inflation is indeed declining, or stable, or whether it continues to drift irregularly higher. My best guess is that the rise in inflation will be very gradual and relatively modest. If I'm right, the Fed is likely to make some modest upward adjustments to its funds rate target later this year and next. None of this should pose a serious threat to the economy or the financial markets, but a tighter Fed would probably give a boost to the struggling dollar, and this could help mitigate the extent to which inflation rises in coming years.
Needless to say, it's going to be very interesting to see how the inflation picture shapes up over the course of this year.