Wednesday, March 11, 2015

Inflation in the 21st century: Oil, not wage growth or unemployment, is the issue

 - by New Deal democrat

This post follows up on my last piece, in which I argued that there are historically non-existent wage or inflationary pressures in the economy, so the notion that the Fed should raise short term rates now to contain such pressures doesn't pass muster.

I'm going to show you that by looking at the Phillips Curve (the tradeoff between the unemployment rate and inflation) in my next piece.

But I can cut to the chase with just one graph.  Here is the CPI for all items (green) compared with core CPI (blue), and CPI less energy (red):

Focus on two things.

First, the red line.  While consumer inflation for all items have gone as high as 5.5%, once we subtract Oil, inflation has only been as high as 3%, and has only exceeded the Fed's target range of 2% once (2012) in the last 6 years, and that only by +0.6%.

Second, as I pointed out in my first piece, the relationship between core and headline inflation is a two way street. Think of the earth-moon system. The center of gravity is not the center of the earth.  The moon doesn't just revolve around the earth, to a limited extent the earth "revolves"  too, wobbling in its orbit in the direction of the moon.  Similarly, just as headline inflation rate tends to revert in the direction of the core inflation over the ensuing 24 - 36 months, so headline inflation accurately forecasts the direction of core inflation over the next 12 months.

Let me delete CPI less energy, and zoom in on that relationship:

Since 2000, there have been 4 peaks and 3 troughs in headline and core inflation.  Here's the record:

Headline // Core
3/00 // 2/01 (11 month lag)
9/05 // 9/06 (12 month lag)
7/08 // 7/08 (simultaneous)
9/11 // 4/12 (7 month lag)

Headline // Core
6/02 // 12/03 (18 month lag)
11/06 // 9/07 (10 month lag)
9/09 // 10/10 (13 month lag)

So to summarize:
  1. core inflation has been below the Fed's target with 1 exception for the last 6 years.
  2. core inflation is likely to decline further below 2% in the next 12 months.
  3. most importantly, inflation ex-oil has been no higher than 3% in the last 15 years, (i.e., irrespective of the unemployment rate or wage growth during that period).
Literally the ONLY thing driving inflation above 3% in the last 15 years has been the secular rise in the price of Oil.  Even at the high point for wage growth and the low point for unemployment.

Raising interest rates in the face of this data would mean that the Fed is treating 2% inflation as a ceiling rather than a target, that it is subordinating its goal of full employment to that ceiling, and that it is beginning to apply the brakes on the economy - and depress wage and job growth - solely because of a possible 1% overshoot, or the possible impact of unrelated higher oil prices in the future.

I'll flesh this out further by showing you the actual Phillips curves in my next post.