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Labor costs are the most important determinant of inflation. With the U.S. economy facing a decade or more of slow growth, the unemployment rate will remain high, labor costs low, and inflation will fade away. -
By Al Ehrbar
Over the long run, it’s the amount of money in the system that determines price levels and thus inflation rates. And yes, they can rise even when the economy is slow. It’s called stagflation.
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David A. Levy
Mild deflation in the years ahead
In the decade ahead, expect inflation to dwindle, giving way to mild deflation. The chance of a sustained pickup in inflation is miniscule. The dominant influence on price trends for years to come will be the deflationary influence of chronically high unemployment.
Labor costs are by far the most important long-term influence on inflation. Although rapidly rising commodity prices can put upward pressure on inflation in the short run, inflation cannot accelerate for long without an acceleration in pay rates. As long as unemployment is high, the present trend toward ever smaller pay raises, more pay freezes, and increasingly common pay cuts will continue.
Let's assume, conservatively, that the unemployment rate only has to fall to 6 percent (considerably higher than in recent business cycles) before compensation inflation begins to reaccelerate. Let's also assume optimistically that unemployment peaks at 10.5 percent in the second quarter of 2010, and falls a percentage point every year—considerably sooner and faster than it did after either of the past two expansions. Even with these assumptions, the unemployment rate would not hit an "inflationary" 6 percent until the end of 2014.
Moreover, these unemployment assumptions are too optimistic because the economy has passed a great watershed and is facing a decade or so of weakness and financial instability. After decades of private-sector balance sheets growing faster than incomes (in the household, nonfinancial business, and financial sectors), the economy has entered a period in which private debt and assets must contract profoundly. This period is a depression, although probably not another "great" depression; thanks to government support for the economy and financial system, it will be a contained depression. The adjustment process will necessarily involve chronically weak fixed investment, weak profits, financial problems, and choppy, overall substandard economic growth. All of these conditions argue for disinflation and some deflation—most certainly not rising inflation.
Many people cite the large government budget deficit as a reason why inflation will eventually rise. However, large government deficits cannot spark rising inflation unless they overheat the economy, and there is little risk of that given the high unemployment, idle capacity, and generally poor growth ahead.
Another common fear is that easy monetary policy will lead to rising inflation as the economy picks up, and many people believe that easy monetary policy necessarily means rising inflation. However, flooding the system with reserves does not under all circumstances lead to additional demand, and if it does not, it cannot affect prices. Presently, excess reserves are not inducing lending for many reasons. The economy would have to be strong for years—long enough to greatly reduce unemployment, raise capacity utilization rates, and shift expectations away from deflation—before the flood of reserves could lead to strong net credit creation, fat profit margins, and upward pressures on prices. That isn't likely before the contained depression ends, and whenever the economy does begin to show sustained strength, the Fed can tighten policy.
What about a dollar collapse leading to higher import prices and thus rising domestic inflation? The dollar may fall significantly further, but there will be no ongoing, downward spiral because such a decline would have severe consequences on the wealth, revenue, and profits of the global economy, much of which is already troubled. The resulting destabilization would lead to flight back to dollars. Still, the dollar could depreciate considerably for a while. If it did, however, much of the exchange rate shift would be absorbed by exporters to the United States. To the extent that U.S. import prices did increase, the impact would be moderate, nonrecurring, and soon outweighed by the weakness in pay trends.
Al Ehrbar
Why we should worry about inflation
Rarely have so many been so optimistic about inflation. Unfortunately, it could turn out that rarely have so many been so wrong.
Few Wall Street economists see a serious risk of sharply rising prices over the next year or so, but elsewhere, people are plainly worried. The Chinese, for example, keep expressing concerns that their trillions in Treasury securities aren't so secure. The declining exchange value of the dollar also reflects fears of differentially higher inflation in the United States.
The principal cause for concern is the vast liquidity that the Federal Reserve created in late 2008 and early 2009. Most economists, even many New Keynesians, have come to accept the monetarist precept that the quantity of money is what determines the price level over the long run. A significant increase in the quantity of money relative to the output of goods and services inevitably translates into higher prices. And never has the quantity of money increased the way it did when the Fed embarked on "quantitative easing" to unfreeze the credit markets and prevent an economic free fall.
All that new money supply hasn't affected prices yet. The reasons are an unprecedented decline in the velocity of money, or the number of times a dollar turns over each year, and a similar drop in the money multiplier, which determines the increase in monetary aggregates like M1 and M2 when the Fed adds to the monetary base. The declines in velocity and the money multiplier also are the major reason that the Fed actions a year ago made sense. No one believes, however, that these declines are permanent. When they reverse, the more than $1 trillion of excess bank reserves that the Fed has created could become the engine of rapidly escalating prices.
The current sanguinity over the inflation outlook reflects two presumptions, one of them simply wrong and the other sadly implausible. The first is the classic Keynesian notion that prices cannot rise fast when there is so much idle capacity. It's as though the Fed and many on Wall Street have completely forgotten the word stagflation. We had it aplenty in the late 1970s, and we could again.
The second presumption, the implausible one, is that the Fed will suck all the extra liquidity out of the system when velocity and the money multiplier bounce back. History and the current political dynamic suggest otherwise. Will the Fed really have the courage and the political latitude to risk aborting a weak recovery solely to contain potential inflation? That clearly is what Mr. Bernanke intends. That also is what the Fed intended throughout the great inflation from the mid '60s through the '70s. But it didn't follow through. Says Allan H. Meltzer, a professor of political economy at Carnegie Mellon University and author of a definitive history of the Fed: "Every effort to do anything about inflation raised unemployment, and the Fed's resolve disappeared."
Paul Volcker did follow through, of course, and defeated inflation in the early 1980s, but he had to resist fierce pressure from Congress to give up the inflation fight in order to combat 10 percent unemployment. With unemployment back at 10 percent, with a 13-digit deficit to finance, with many in Congress calling for more direct oversight of monetary policy, and with a crucial mid-term election coming in November, it seems rather bold to assume that Bernanke will exhibit Volcker-caliber courage, or that Barack Obama will provide the political cover he'll need. It has to be at least as likely that the Fed will err on the side of jobs, and do so over and over, until the public again decides that inflation is the major problem. Last time around, that didn't happen until inflation got to 13 percent.
07 May 2010 · 08:42:14 PM GMT
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Study, “smudy.” Gentlemen, nobody knows nothing. I too have modelled etc. I have also lived, and am living in Japan. Before we get all excited about our models and what our economics backgrounds tell us. I urge all of you to consider the meaning of a Balance Sheet Recession (BSR).
Everything points to this period being one of the great asset/financial/social dis-locations. Just look at the volatility figures from 1929/1930 and compare to now. Vix/Volatility is an excellent measure of human behaviour expressed through securities prices. And they are saying something crucial has happened.
What a BSR entails is corporations and individuals paying down their debt over-hangs. And it’s slow and painful process. Some will bite the bullet ASAP, some will take longer and be on the Gov’t ‘tit’ (sorry call it as I see it) enabling them to survive years after they should have changed behaviour. I note Japan Airlines just went into bankruptcy protection with well over $16 billion in liabilities and only roughly $2 billion in revenues. No where is the question asked, investigated, or pondered, HOW did that happen? Do the Nikko hotels in London, Singapore, Chicago, Frankfurt ring a bell?
Yes, it’s exceedingly fair to say ‘apples and oranges’ comparison with Japan and USA currently. The point is, however,that corporates and individuals behave differently in such an environment (paying down debt, not making capex investments). And secondly, how a government is required to act (ie pick up the spending slack by monetary stimulus).
I don’t mean to digress into Japan but it is interesting to note how ‘unsuccessful’ they have been on the surface (note the size of the economy is roughly similar to where it ended during the last top of Heisei bubble in 1989). If anything should give us pause it’s that fact. They didn’t grow, they didn’t necessarily contract but they definitely didn’t grow.
That, I HOPE, is the best we may be able to hope for.
FYI, the BSR concept is written about by Richard Koo.
Posted 21 January 2010, 00:44 by Eduardo Galiano
It is hard to see why the present time is analogous to the 1970’s. Several factors combined to cause that inflationary period. After several years of healthy growth and low inflation in the 1960’s, Johnson’s policy of “Guns and Butter” strained the country’s resources and inflation began to creep in. When the recession of 1969-70 did not eliminate it, the Nixon administration put in price controls (1971 or early 1972) which significantly reduced the incentives for businesses to invest in incremental capacity. Add into the mix a spineless Fed under Burns, and the first oil shock and one has a great combination for inflation. The lack of a pricing mechanism due to price controls hindered the normal adjustments from taking place. When the price controls came off in the summer of 1974, the economic decline could not restrain the inflationary pressures. The present situation is missing several of the factors present back then.
That being said, the continuing rise in commodity prices, a declining dollar, and very stimulative fiscal and monetary policies should not let anyone dismiss the potential for accelerating inflation.Posted 19 January 2010, 13:46 by Stephen O'Brien
Inflation or not is decided by somebody (Fed ?), is not coming from Mars. The problem is. We want inflation or not. Meaby Fed know how to do (i hope). What i think is that it needs a planetary inflation, more then usual 5%/year (meaby 10% for several years). Otherwise comunism (or at least condition of living like in communism)is knoking on door. And belive me communism is a very bad think.China had enough time to invest his mony. Its time to adjust the US and EU economys.(for who read excuse my poor English)
Posted 19 January 2010, 09:30 by NELU NICU GHITA
As long as the US maintains its innovation edge its predominance is assured.What makes The US great is its commitment to mertiocracy and innovation.Its selective immigration policy ensures churning of the gene bank.
All past paradigms and rules have been shown the door.I think we need to begin from first principles.
As long as the US reinvents itself-its dominant position is assured.
It was America’s choice that she allowed China to be the dominant producer and manufacturer.
Posted 18 January 2010, 20:33 by Pijush Das
Although the increase in base currency has been exceptional, the change to the policy of interest payments on excess reserves has meant that the actual velocity of Dollars in real circulation remains fairly flat.
Combined with the extreme level of debt overhang this is therefore a fundamentally deflationary environment although a bizarre one where monetary policy has supported higher order economic factors such as asset and commodity values.
This dilemma means that deflationary and inflationary factors are largely cancelling each other out. If assets can gain additional support from successful even greater stimulatory effects then this is potentially inflationary. I personally don’t see this being sustainable but time will tell. Also if the Fed aren’t able to drain excess reserves that is the greater danger of inflation/hyper-inflation. These changes apart, the prevailing conditions are deflationary and likley to remain so for some considerable time. It could go either way but many of the inflationists’ arguments are quite poorly founded and they mis-state the real inflationary dangers. Also, do remember that economists define inflation in relation to money supply – which is a lot more meaningful measure than CPI.
Paul
Posted 17 January 2010, 10:44 by Paul Gambles
There is a strong correlation between gold prices and dollar. Similarly crude prices also have established strong relationship with dollar. It is estimated that gold prices may touch $5000 and this becomes true dollar must weaken. Generally, central banks intervenes when the domestic currency weakens. But Fed is helpless because they cannot hike the interest rate for of fear of pushing the country to a further receession. On the other hand China will continue to adjsut Yuan to dollar for supporting export growth. However, countries like India may face issues like slow export growth on account of weak dollar unless the central bank intervenes strongly to prevent domestic currency appreciating beyond a particular level. Further, we have to look into the initiatives by a group of Asian countries as also Gulf countries to launch their own regional currencies. The emergence of regional currencies may pull down the dollar uppehand on global economy. However, Obama administration is pledged to revive the economy. Hence largescale unemployment is not expected. But US may face inflationary pressures and the dollar may weaken in the coming days.
Posted 16 January 2010, 02:00 by Dr. Sasidharan. K
Even in the 1970s wage inflation came AFTER increases in basic materials and producer prices. Basic materials and producer prices are every bit as responsive to loose money today as they were in the 1970s, perhaps even more so because of the financialization of business—some people call commodities an asset class and there are far more ways to speculate on them. I think businesspeople know that the sequence of accelerating inflation runs (1) rising market-sensitive materials prices then (2) intermediate goods prices go up for products that use a lot of those sensitive materials then (3) prices of products that have more labor, intellectual property and branding go up to catch up and lastly (4) workers realize that their purchasing power has been eroded by price increases and as they work to maintain a steady standard of living, they seek wage increases. For unskilled employees, the ouput gap definitely will restrain wages, but skilled employees will have other options.
Posted 15 January 2010, 16:57 by jct
Al Ehrbar points to the decline in the velocity of money as the reason for containment of inflation. What about the fact that a lot of liquidity has moved out of America for investment in countries like Brazil, Turkey, India, Russia, China etc?
The near zero interest rates on US$ has helped this carry trade. Brazil has in fact imposed a tax on foreign investments to stem the tidal inflow of US$ that were meant to stimulate demand in USA.
Posted 14 January 2010, 10:12 by Kamal Gupta
Most of this seems to come down to defining inflation and what is included in such factors as CPI or even MV=PQ. I don’t believe that these things today have any relationship to what they meant when most of the currently in place economic theories were created. The impact of recent trends including globalization and the growing emergence of a middle-class around the world has only exacerbated this shift in reality.
We can look societies and the related economic developments as intertwined events. The hunter-gatherer society economy meant that value was placed on near-term survival; therefore ‘spending’ (in this case personal time) was very transactional. When societies shift to become agricultural, economics and ‘spending’ are still very near-term driven but the very nature of farming starts to reward the accumulation of assets for the future (e.g. next year’s crop is planted from this year’s seeds). Earning potential was still very risky however, determined in part by natural events. When industrialization followed, we had greater earning power but also less risk of future uncertainty, since employment was generally assumed to be lifetime meaning a guaranteed income stream. Savings became a byproduct, spending came close to earning for the average person. At the same time, however, the middle class blossoms and suddenly experiences the event of having more income than is needed for basic necessities (as usually measured in CPI). This in some ways drives the next societal change to service-based economies, which serve to absorb some of the excess income by providing services instead of hard goods which in turn is the beginning of decoupling value from production cost. This is the ecomonomic and societal stage that drove much of the late 80’s and 90’s. Note that this stage lasted less than approximately 20 year’s, whereas the previous were measured in decades or centuries. Like in everything else, the velocity of societal and economic change has accelerated beyond anything seen or experienced in the past.
Our current society and economics is now based more on money than anything else. The result has been the steady growth of both tangible and intangible assets, at rates well beyond what is measured in most inflation indices. The acceleration of growth of the mass affluent and high net worth populations have fueled this cycle of growth. What is most important here is that value of many of these assets is not tied to any physical or even rational limiting factor beyond purely “what the market will bear?” As a result there are no self-regulating forces at work, as would normally (eventually) kick in following a hard goods supply versus demand scenario. And perhaps most devastating, if money is itself the ‘asset’ being pursued, and money is increasingly both borderless and can move at the speed of light (literally), then old school supply and demand models that are defined for constraint-based markets are completely obsolete.
As an example of this, look at real-estate in the US. The adage that real estate value is based on three things – location, location and location – held true up until the very recent past. Now real estate valuations can and do fluctuate wildly, with location driven more as a result of marketing and perceptions than physically determined. As a result, the supply of ‘valuable’ land is decoupled from the availability of ‘good’ land and the prices spiral out of control. Replace real estate with any other wealth accumulation asset and the same holds true.
So what does this mean? We need new economic models and theories to accommodate the new global economic model. Supply and demand is no longer tied to hard-goods or other self-regulating realities, but must instead be able to adjust to and be determined by more intangible factors. Adhering to the old methods and thoughts to guide economic policy decisions in the current world will lead to disaster, or at least produce no better results than we experienced over the last couple of years. And cyclical disruptions are here to stay as the borders for money continue to erode.
Posted 14 January 2010, 09:47 by Toby Miller
Reacting to Mr. Ehrbar's reflection on the low utilisation rate of the 1970s not preventing a high inflation rate.
I think the fundamental difference between the 1970s and today is the absence of price setting power of the production factor “labor”. Indeed, in the 1970s the unions were very powerful and managed to have the purchasing power of employees adjusted with the rising oil prices. This in turn resulted in a price-wage spiral.
Today, this is hardly possible, with the globalised world and strong deflationary price pressures coming from emerging countries. High oil prices now need to be seen as a tax and ultimately self-defeating for non-competitive economies.
There are indeed huge amounts of money sloshing around in “the system”, but hardly anybody describes this system… As long as this liquidity doesn’t reach the final consumer propping up his purchasing power, the risks of hyperinflation seem rather low.
To me, it all boils down to one essential element : purchasing power, either directly via a price-wage spiral, or indirectly via a lending boom to consumers. As long as this liquidity stays in the financial system, we will (are ?) getting high and rising asset prices, ultimately leading into financial bubbles, manias, etc.
Posted 14 January 2010, 02:49 by Kris Temmerman