Two interesting inflation charts
THE Bureau of Labour Statistics has released its latest inflation figures, providing us with an opportunity to reflect on where the American macroeconomy is heading. The producer price and consumer price releases showed similar trends. Both core and headline inflation ticked up, but the core increase was much more subdued. Core producer prices rose 2.1% in the 12 months to April, up from 2.0% in March. Core consumer prices rose 1.3% in the 12 months to April, up from 1.2% in March.Both core CPI and core PCE (the Fed's preferred measure of inflation, taken from the GDP release) are signaling a healthy increase in inflation that remains within the Fed's comfort zone. (The annualised rate of inflation over the past three months is probably a little hot for the Fed's taste, but it also believes that as commodity prices level off upward pressure on prices will ease.) A dose of inflation is a good thing for an economy at this point in the business cycle. Have a look at the path of the real interest rate, as calculated by the Cleveland Fed:It's negative! That's a good thing, too. Back in January, I wrote up a talk given by economist Robert Hall on the dismal state of the American labour market:Robert Hall, an outstanding economist and an entertaining speaker, began by directing attention to a few key measures of lending conditions for small businesses and consumers. He pointed out that at the onset of crisis these measures deteriorated significantly and they have yet to improve all that much. It seemed to him that this had to be connected to the continued high level of unemployment.Mr Hall constructed a model, some of which he presented in the session and some of which came out later in his presidential lecture, in which the crisis gives rise to "financial frictions". Lenders must then be induced to provide additional credit through reductions in the real interest rate. But, he pointed out, interest rates are constrained by the zero lower bound. In his model, it might take a real interest rate of something like -2.5% to clear the economy. But obviously the Fed is constrained once nominal rates hit zero, and so the economy returns to its trend growth rate but never recovers the ground lost during the financial shock.He argued that the Fed was basically powerless to return the economy to full employment once rates hit zero, which confused me at the time. After all, all the Fed has to do is create some inflation to generate negative rates. And as we see above, the real interest rate is around the level Mr Hall said was necessary to produce rapid job growth.But there's a twist in this story: inflation expectations aren't rising. They're falling:You can see that in the very short term, inflation expectations have risen, but for horizons greater than a year, they're below 2%, and beyond three years, they're actually below the level as of a month ago. Over the 10-year time frame, markets expect average inflation to be 1.86%.This could be a one-month blip, but it's something that's worth watching very closely. Late last spring, inflation expectations began falling sharply as growth expectations began falling sharply. This coincided with a nasty stretch of economic activity, during which job growth was minimal and fears of a return to recession rampant, that ended only when the Fed began broadcasting its intention to embark on QE2. It's possible that crisis in Europe and Japan and slowing emerging market growth may be weighing on expectations.The Fed isn't going to make any decisions based on data from one month. But the above strongly supports the argument that inflation is not about to spin out of control, and it reinforces the vulnerability of America's recovery.