Thursday, September 18, 2008

Amid Other Concerns, Don't Worry About Inflation

The Consumer Price Index (CPI) last month rose more than 5% over a year earlier, way above a rate that is consistent with price stability. At the same time, the federal-funds rate is at 2%, so the real interest rate on federal funds -- the interest rate adjusted for inflation -- has turned very negative.

Will this low real interest rate lead to inflation spiraling out of control? Shouldn't the Fed react more to the currently high inflation numbers by tightening policy, a view often advocated on this page, or at least not further lower the fed-funds rate if the economy looks like it might go into a tailspin? The answer is no.

While headline CPI inflation over the past year was above 5%, core CPI inflation was around 2.5% (about the same as the 2.4% average since 1994, see top chart above). With the sharp decline in oil prices from over $140 per barrel to below $100 now, and the decline in other commodity prices, headline inflation should fairly quickly move back towards core inflation.

If the monetary authorities react to headline inflation numbers, they run the risk of making serious policy mistakes. We have seen that headline inflation has risen well above its underlying trend as the price of energy has risen. But with energy prices having fallen, it will soon fall back to or below its underlying trend. A tightening of monetary policy in reaction to the rise in headline inflation would lead to a decline in employment and inflation. Because of the long lags between monetary policy actions and changes in economic activity, that decline would occur sometime down the road, when inflation would more likely be at or below its underlying trend.

One widely watched measure called the break-even inflation rate -- the difference between yields on longer maturity Treasury Inflation Protection Securities (TIPS) and Treasury bonds -- has fallen substantially in the last couple of months (see bottom chart above, the spread is now below 1.8%, the lowest in more than 5 years). Not all of this decline should be attributed to falling longer-run inflation expectation -- break-even inflation also is affected by inflation uncertainty and liquidity considerations. But it certainly suggests that inflation expectations are more likely to be falling rather than rising.

Columbia professor Frederic Mishkin
in today's WSJ

MP: I'm with Mishkin on this issue. There might be a lot of serious concerns about the economy and financial markets, but inflation isn't one of them. Worry about issues, but as Mishkin says, "don't worry about inflation."


At 9/18/2008 9:30 AM, Anonymous qt said...

Looks like you spoke too soon - another looming financial crisis on the horizon.

Keep smiling :)

At 9/18/2008 11:57 AM, Anonymous Machiavelli999 said...

Carpe Diem acknowledges that there are problems in our economy. If that is not a sign of at least a temporary bottom, I don't know what is.

At 9/18/2008 12:34 PM, Anonymous Anonymous said...

Worry about DEFLATION

Anyone talking about inflation is looking in the rear view mirror.

At 9/18/2008 6:05 PM, Anonymous Anonymous said...

I suspect inflation is not a worry at this time. However, what about the effect of all that money being artificially created in responding to the credit crisis? Inflating the money supply can easily lead to inflation. And inflating the money supply is occurring worldwide.


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