Thursday, January 7, 2010

Is Inflation a Legitimate Threat for 2010???

Is inflation a legitimate threat in the year 2010?? Well my fellow adventurer on the 3rd planet from the sun, according to Kevin L. Kliesen of the Federal Reserve Bank of St. Louis, it may be.  He has a relatively short, informative paper with some nifty graphs located at the St. Louis Federal Reserve Bank website.

Kliesen says that economic conditions are "on the mend".  Now comes the very intricate and thorny part for policymakers:  not raising rates prematurely and killing the recovery before it's hardly begun, or the opposite evil, keeping rates low for too long, and making conditions fertile for potential inflation.  It could be a very fine line to walk for the FOMC.

Some knowledgeable people believe that inflation will remain low, as long as the unemployment rate stays high, or above the "natural" rate of unemployment.  Of course some of us "Joe six-packs" find the idea of a  "natural" rate of unemployment highly annoying.  But the truth is that the vast majority of economists see a natural rate of unemployment as somewhere around 4% to 5%---roughly.  Currently, we have unemployment around 10.2% by official counts (some people believe it's actually higher).  So, if you're just using unemployment alone as a gauge, then chances for inflation would seem nil. Other very knowledgeable people take a very different view of events.  They believe the chances of inflation have gone up because of the Federal Reserve's asset purchase program and recent increases in the deficit.

In my opinion, recent and drastic increases in the deficit were mainly caused by Bush's policies on war, Bush's prescription drug benefit plan started in 2006, and the economic crisis which began on Bush's watch---my thoughts not Kliesen's.

Kliesen believes that this recession which has gone from 2007 to at least 2009, is in many facets the worst we have had since the 1930s (Great Depression time).  But unemployment is not the worst it has been since World War II.  The worst unemployment America has experienced after World War II was in late 1982 when the unemployment rate was 10.8%.  Kliesen says that given the extended time frame of some past recessions, it is not mysterious why Summers and Bernanke took some extreme policy moves in response.

Kliesen presents an excellent graph in his paper.  It shows in a simultaneous time frame, the changes the Federal Reserve (Bernanke) made in the monetary base and federal funds target rate.  I'll let Kliesen give you the details there, as he does just below that graph (Figure 1).  The main point you need to know is the Federal Reserve raises the monetary base to fight inflation, and also lowers the federal funds rate to fight inflation.  So it shows you the time frame and how drastic those moves were.  The main thing to come away from here is that the monetary base has become much much larger between January 2007 and August 2009 (more than double).  But this increase in the monetary base has not yet resulted in an increase in the money supply.  Although the monetary base doubled, the M2 measure of money supply only increased 17%.  In essence, in very simplified terms what does this mean???  It means the Federal Reserve can put money into the banks' reserves, but the Federal reserve can't force banks to loan it out.

After this breakdown, Kliesen asks the $64,000 Question---what is the best way to forecast inflation?  And here Kliesen gives us another great graph.  It show the 10 least optimistic forecasts for the Consumer Price Index (CPI) and plots it in a beige colored line, the 10 most optimistic forecasts and plots it in a orange line, then takes the difference (disagreement) and shows that with a blue line.  As you see on the right side of Kliesen's graph, disagreements on future inflation have increased most recently. Obviously, people's views of the future rate of inflation is colored by the way or method they think is best to forecast inflation.  And in this post I am not going to get into the details--Kliesen does that nicely and you can read it there (and it's constructive info).  The main point I will give you here is that many members of the FOMC think that the Philips Curve (New Keynesian model) is a solid way to predict inflation.  In other words:  Philips curve is part of their mindset when they make rate recommendations at FOMC meetings.

The biggest potential snafu with Philips Curve is predicting "slack".  What is slack??? Slack here means the difference between actual real GDP and an estimate (guess) of potential real GDP.  It's very very difficult to estimate the size of this gap (or slack).  Hence it leaves a pretty large possible margin of error in calculation of the Philips Curve.

Other factors which can throw the inflation forecasts off: large increases in oil prices, foreign economic developments (Asian Contagion comes to mind, and Dubai more recently).

Kliesen goes into much further detail on all this. But the main point he seems to be making is yes inflation is a legitimate concern for policymakers and all Americans looking forward.  But he also seems to think there are tools to answer it.

My personal opinion is, inflation will not be a threat for all of 2010, because unemployment will be to high.

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