Inflation Still MIA
Monday, May 2, 2016
(1) Central bankers are overdue to have second thoughts. (2) A heretical idea. (3) Three non-monetary drivers of inflation. (4) CPIs in Eurozone and Japan are comatose. (5) Volcker’s lesson. (6) Good old days for Phillips Curve. (7) Output gap, demand-pull, cost-push, and Janet Yellen. (8) Subdued wage inflation continues to surprise Fed officials. (9) Why aren’t consumers happier given record real incomes and consumption per household? (10) Low investment returns depressing consumers and boosting their saving.
Central Banks: Undershooting Their Targets. It may be time for the major central banks to consider why their ultra-easy monetary policies haven’t revived inflation. Could it be that inflation isn’t always and everywhere a monetary phenomenon? Debbie and I actually have been promoting this heretical view for many years. Globalization has unleashed powerful competitive forces in product and labor markets. Technological innovation is constantly disrupting established business models, especially ones that incorporate price and wage increases. Demographic trends, particularly aging populations (as people live longer and fertility rates plunge around the world), also may keep a lid on inflation. These are among the major factors that have been pushing CPI inflation down ever since it peaked in the US at 14.8% during March 1980 (Fig. 1).
This certainly explains how we can have a 157% increase in the assets of the Fed, the ECB, the BOJ, and the PBOC (all priced in dollars) since January 2008 while inflation remains subdued (Fig. 2). Actually, it’s more like inflation is in a coma, particularly in the Eurozone and Japan, where the monetary doctors have tried to revive it with numerous rounds of monetary CPR shocks. The CPI inflation rate was -0.2% y/y in the former, with the core rate edging down to 0.7% during April (Fig. 3). Similarly, in Japan, the headline inflation rate was -0.1% and up 0.7% on a core basis during March (Fig. 4). In the US, the CPI and PCED inflation rates were 0.9% and 0.8% during March, while their comparable core rates were 2.2% and 1.6% (Fig. 5 and Fig. 6).
With the exception of the headline US CPI inflation rate, all of the above numbers are below 2.0%, which the major central banks deem to be their legally mandated targets for inflation. The US CPI gives rent (up 3.2% y/y) a very high weight of 32% of the overall index, including both tenant rent (up 3.7%) and owner-occupied rent (up 3.1%) (Fig. 7). The latter is an odd duck, showing what homeowners hypothetically would have to pay themselves in rent if they were their own landlords. Rent accounts for only 15% of the PCED. Excluding this item, the PCED headline and core rates are 0.4% and 1.2%.
Debbie and I were early disinflationists at the beginning of the 1980s. Back then, Fed Chairman Paul Volcker tightened monetary policy, pushing the economy into a severe recession from Q3-1981 through Q4-1982. Inflation fell sharply, confirming that recessions, especially severe ones, can reduce inflation. That wasn’t the case during the 1970s, when the oil shocks of 1973 and 1979 boosted inflation and at the same time pushed the economy into recessions.
Back then, more workers in the private sector were unionized, and many of their contracts included cost-of-living adjustments (COLAs) (Fig. 8). Data starting in 1983 show that the percentage of unionized workers fell from 16.8% that year to 6.7% during 2015. The percentage of unionized public employees has remained relatively stable between 35% and 40% over this same period. Rising labor costs in the public sector are more likely to lead to deflationary tax increases than inflationary price increases.
During the 1960s and 1970s, companies could easily pass along rising labor and energy costs into prices. Back then, there was a widespread view that inflation would remain an intractable problem as higher wages led to higher prices, with a feedback loop back into wages. Productivity languished. In fact, auto workers’ contracts included pay hikes tied to assumed productivity goals, which were never realized.
The 1960s and 1970s were the heydays for the Phillips Curve, which posits that there is an inverse relationship between slack in the labor market, usually measured using the unemployment rate, and both wage and price inflation. The presumptions were that tight labor markets would push up wages and that cost-push pressures would push up prices. Of course, there was also a demand-pull mechanism at work, which was boosting the demand for goods and services and the demand for labor.
All these inflationary forces could be summarized by the Output Gap Model. When actual GDP was less than the potential output of the economy, as determined by supply-side factors of available labor force and its growth along with productivity, inflation was expected to decline. When this output gap narrowed, inflation was expected to increase. Measuring the output gap is as hard as measuring productivity. So the model isn’t very useful in practice. Its theoretical basis is also questionable given our view that there are numerous other factors that are impacting inflation, and currently keeping it subdued below the central bankers’ 2.0% target despite their best efforts to boost it.
Meanwhile, Fed officials just won’t listen–to us, anyway. They still believe in the Output Gap Model along with the Phillips Curve. They believe they can stimulate demand by continuing to provide ultra-easy money, thereby tightening the labor market, which should drive up wages. Once the demand-pull mechanism has done its job, then the cost-push mechanism should get into gear and push inflation higher. Fed Chair Janet Yellen has been the most vocal proponent of this approach.
She is still waiting for it to work. Wage inflation remains subdued. She has particularly stressed the importance of the wage component of the Employment Cost Index (ECI). As Debbie reports below, private-sector wages and salaries in the ECI rose just 2.1% y/y during Q1 (Fig. 9). Also at the center of Yellen’s labor market “dashboard” is average hourly earnings, which rose just 2.3% y/y through March (Fig. 10). It still looks like either one-and-done or none-and-done this year for Fed rate-hiking, which had been our forecast for last year as well.
US Consumers: For Better or Worse? Why is consumer confidence down, and why are consumers saving more? Every month, Debbie and I derive the Consumer Optimism Index (COI) by averaging the Consumer Sentiment Index and the Consumer Confidence Index (Fig. 11). The overall COI rose to a cyclical peak of 101.0 during January 2015. It was down to 91.6 last month. The COI’s present component remains near its recent cyclical high, but the expectations component is down sharply from its cyclical peak of 94.0, also during January 2015, to 78.5 currently. Over this same period, payroll employment has increased 3.2 million and the pump price of gasoline has dropped 6%, following a 29% drop during 2014. (See our Consumer Confidence.)
Why is the 12-month sum of personal saving up $73 billion to $684 billion since June 2014 (Fig. 12)? On a per-household basis, personal saving is up $547 to $5,823 at an annualized rate over this period (Fig. 13). That suggests that consumers might have saved almost half of their gasoline windfall, which has been $1,302 per household at an annualized rate since June 2014 through March of this year.
The broadest measures of consumers’ well-being are at record highs (Fig. 14). Real total and disposable personal incomes per household were there during March with y/y gains of 2.9% and 2.7%. Real consumer spending per household rose 2.2% y/y through March also to a record high, of $97,078. Previously, we’ve argued that the annual income measures used by naysayers to claim that the standard of living in America has stagnated for the past 15 years are flawed and misleading for a number of reasons. (See “Demography & Inequality” in the 3/29 Morning Briefing.)
So what’s the matter? Could it be that the Democrats and Republicans are about to give us a choice between two of the most unpopular presidential candidates in history? Yes. Could it be that ObamaCare has caused health insurance premiums, deductibles, and co-pays to soar? Yes. Could it be that historically low interest rates are forcing consumers to save more? Yes. Could it be that many individual investors are depressed that they didn’t put more money into stocks a few years ago, and now deem them to be too expensive and risky? Yes.
It may be that all these concerns are weighing on consumer confidence and spending. They seem to be weighing more on older Americans (Fig. 15). The Consumer Confidence Index (CCI) is available for three age groups: under 35 year olds, 35-54 years old, and 55 and older. The youngest group has the highest CCI, which just about matches the previous cyclical high during 2006. The middle-aged group has the second-highest CCI, which has stalled out over the past year below the previous cyclical high. Older Americans have the lowest CCI of the three, and it has been trending downwards over the past year. Speaking on behalf of this group, I think we are older and wiser.