Tag Archives: Trimmed CPI

Fiscal Inflation Is Simple With This One Weird Trick

03 Thursday Feb 2022

Posted by in Fiscal policy, Inflation

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I’ll get to the weird trick right off the bat. Then you can read on if you want. The trick really is perverse if you believe in principles of sound credit and financial stability. To levy a fiscal inflation tax, all the government need do is spend like a drunken sailor and undermine its own credibility as a trustworthy borrower. One way to do that: adopt the policy prescriptions of Modern Monetary Theory (MMT).

A Theory of Deadbeat Government

That’s right! Run budget deficits and convince investors the debt you float will never be repaid with future real surpluses. That doesn’t mean the government would literally default (though that is never outside the realm of possibility). However, given such a loss of faith, something else must give, because the real value government debt outstanding will exceed the real value of expected future surpluses from which to pay that debt. The debt might be in the form of interest-bearing government bonds or printed money: it’s all government debt. Ultimately, under these circumstances, there will be a revised expectation that the value of that debt (bonds and dollars) will be eroded by an inflation tax.

This is a sketch of “The Fiscal Theory of the Price Level” (FTPL). The link goes to a draft of a paper by John Cochrane, which he intends as an introduction and summary of the theory. He has been discussing and refining this theory for many years. In fairness to him, it’s a draft. There are a few passages that could be written more clearly, but on the whole, FTPL is a useful way of thinking about fiscal issues that may give rise to inflation.

Fiscal Helicopters

Cochrane discusses the old allegory about how an economy responds to dollar bills dropped from a helicopter — free money floating into everyone’s yard! The result is the classic “too much money chasing too few goods” problem, so dollar prices of goods must rise. We tend to think of the helicopter drop as a monetary policy experiment, but as Cochrane asserts, it is fiscal policy.

We have experienced something very much like the classic helicopter drop in the past two years. The federal government has effectively given money away in a variety of pandemic relief efforts. Our central bank, the Federal Reserve, has monetized much of the debt the Treasury issued as it “loaded the helicopter”.

In effect, this wasn’t an act of monetary policy at all, because the Fed does not have the authority to simply issue new government debt. The Fed can buy other assets (like government bonds) by issuing dollars (as bank reserves). That’s how it engineers increases in the money supply. It can also “lend” to the U.S. Treasury, crediting the Treasury’s checking account. Presto! Stimulus payments are in the mail!

This is classic monetary seigniorage, or in more familiar language, an inflation tax. Here is Cochrane description of the recent helicopter drop:

“The Fed and Treasury together sent people about $6 trillion, financed by new Treasury debt and new reserves. This cumulative expansion was about 30% of GDP ($21,481) or 38% of outstanding debt ($16,924). If people do not expect that any of that new debt will be repaid, it suggests a 38% price-level rise. If people expect Treasury debt to be repaid by surpluses but not reserves, then we still expect $2,506 / $16,924 = 15% cumulative inflation.”

FTPL, May I Introduce You To MMT

Another trend in thought seems to have dovetailed with the helicopter drop , and it may have influenced investor sentiment regarding the government’s ever-weakening commitment to future surpluses: that would be the growing interest in MMT. This “theory” says, sure, go ahead! Print the money government “must” spend. The state simply fesses-up, right off the bat, that it has no intention of running future surpluses.

To be clear, and perhaps more fair, economists who subscribe to MMT believe that deficits financed with money printing are acceptable when inflation and interest rates are very low. However, expecting stability under those circumstances requires a certain level of investor confidence in the government fisc. Read this for Cochrane’s view of MMT.

Statists like Bernie Sanders, Alexandria Ocasio-Cortez, and seemingly Joe Biden are delighted to adopt a more general application of MMT as intellectual cover for their grandiose plans to remake the economy, fix the climate, and expand the welfare state. But generalizing MMT is a dangerous flirtation with inflation denialism and invites economic disaster.

If This Goes On…

Amid this lunacy we have Joe Biden and his party hoping to find avenues for “Build Back Better”. Fortunately, it’s looking dead at this point. The bill considered in the fall would have amounted to an additional $2 trillion of “infrastructure” spending, mostly not for physical infrastructure. Moreover, according to the Congressional Budget Office, that bill’s cost would have far exceeded $2 trillion by the time all was said and done. There are ongoing hopes for separate passage of free community college, an extended child tax credit for all families, a higher cap for state and local income tax deductions, and a host of other social and climate initiatives. The latter, relegated to a separate bill, is said to carry a price tag of over $550 billion. In addition, the Left would still love to see complete forgiveness of all student debt and institute some form of universal basic income. Hey, just print the money, right? Warm up the chopper! But rest easy, cause all this appears less likely by the day.

Are there possible non-inflationary outcomes from ongoing helicopter drops that are contingent on behavior? What if people save the fresh cash because it’s viewed as a one-time windfall (i.e., not a permanent increase in income)? If you sit on such a windfall it will erode as prices rise, and the change in expectations about government finance won’t be too comforting on that score.

There are many aspects of FTPL worth pondering, such as whether bond investors would be very troubled by yawning deficits with MMT noisemakers in Congress IF the Fed refused to go along with it. That is, no money printing or debt monetization. The burgeoning supply of debt would weigh heavily on the market, forcing rates up. Government keeps spending and interest costs balloon. It is here where Cochrane and critics of FTPL have a sharp disagreement. Does this engender inflation in the absence of debt monetization? Cochrane says yes if investors have faith in the unfaithfulness of fiscal policymakers. Excessive debt is then every bit as inflationary as printing money.

Real Shocks and FTPL

It’s natural to think supply disruptions are primarily responsible for the recent acceleration of inflation, rather than the helicopter drop. There’s no question about those price pressures in certain markets, much of it inflected by wayward policymakers, and some of those markets involve key inputs like energy and labor. Even the median component of the CPI has escalated sharply, though it has lagged broader measures a bit.

Broad price pressures cannot be sustained indefinitely without accommodating changes in the supply of money, which is the so-called “numeraire” in which all goods are priced. What does this have to do with FTPL or the government’s long-term budget constraint? The helicopter drop certainly led to additional money growth and spending, but again, FTPL would say that inflation follows from the expectation that government will not produce future surpluses needed for long-term budget balance. The creation of either new money or government debt, loaded the chopper as it were, is sufficient to accommodate broad price pressures over some duration.

Conclusion

Whether or not FTPL is a fully accurate description of fiscal and monetary phenomena, few would argue that a truly deadbeat government is a prescription for hyperinflation. That’s an extreme, but the motivation for FTPL is the potential abandonment of good and honest governing principles. Pledging an inflation tax is not exactly what anyone means by the full faith and credit of the U.S. government.

Stagflation and the Supply of Bad Public Policy

20 Wednesday Oct 2021

Posted by in Inflation

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Price inflation is getting more attention now than it has in many years, but not everyone is convinced it will persist, most conspicuously bond investors. The Biden Administration’s initial narrative was plausible even if there were seeds of doubt: a price spike was to be expected relative to the low-ebb of price changes during the pandemic. However, the inflation data has come in strong since the spring, and events point to continuing price pressures and the potential for expected inflation to drive escalations in contract pricing. Once embedded like that, the phenomenon broadens and gets harder to squeeze out.

Broadening Price Hikes

The evidence at hand is never enough to take much comfort in predictions, and the uncertainties now are similar to those I discussed in June. At the time, the price moves had been pronounced only in the prior month or so, and there was no evidence of any breadth. Now, it’s at least clear that increases in the so-called “core” Consumer Price Index (CPI), which excludes food and energy prices, have escalated. In addition, the growth in the median component of the CPI basket reported by the Federal Reserve Bank of Cleveland has begun to jump. So has the “trimmed CPI”, which excludes the most extreme 8% of prices changes in both directions within the index. The chart below shows one-month changes in these gauges:

So the recent upward price trends have expanded in breadth, and their persistence is making it a little harder to argue that the changes are transitory rebounds from pandemic weakness.

Bond Investors Still Nonchalant

Investors are by no means convinced that the recent price pressures will persist. They have an incentive to bid-up bond yields to compensate for expected inflation, so these yields can be used to infer inflation expectations. The chart below from the Federal Reserve Bank of St. Louis shows the five-year “breakeven” inflation rate, which is derived from inflation-indexed versus unindexed Treasury securities.

The pattern does not suggest that a meaningful change in inflation expectations has taken place. In fact, the implied five-year inflation forecast has edged down a bit. Of course, we’re still worrying about a fairly short period of high month-to-month changes in prices, and five years is a long time in that context.

This “casual” reaction of interest rates to the inflation spike undoubtedly reflects investors’ belief that the Federal Reserve will tighten policy in an effort to contain inflation. Some of us have strong doubts about the Fed’s inflation-fighting resolve, however. There is little the Fed can do to relieve supply-side problems, and many would argue that the Fed should take an accommodative stance in an attempt to minimize output and job losses, but that would reinforce the inflationary effects. There is no easy way out. Risks loom in both directions, and though I might regret it, at recent yields, I’m not buying Treasury bonds.

Sources of Price Pressure

Economists have tended to divide price pressures into those driven by demand and those driven by supply. Sometimes the terms “demand-pull” and “cost-push” inflation are used for shorthand. The former is usually associated with economic growth, where rising prices indicate that demand is outpacing gains in capacity. With cost-push inflation, however, rising prices indicate that production snd supply is somehow impeded. You get higher prices and lower output. This is so-called “stagflation”. Today we seem to have a combination of those inflationary forces in play: demand has rebounded from the pandemic lows of 2020, while breakdowns in the supply chain have choked production, with a consequent need for more severe price rationing. If the latter forces win out, we will have entered a stagflationary episode.

Unfortunately, administration policies are exacerbating supply-side inflationary pressures. Officials first insisted that the jump in inflation measures would be transitory. More recently they’ve said that it really only hurts “the rich”, an assertion that is decidedly false. Biden flaks are doing their level best to put lipstick on a pig. “Peppermint” Psaki says it shows that people just want to buy things! On the other hand, the Washington Post encourages us to “lower our expectations”. Um, yeah… I think we’re there!

Burning Energy Producers and Consumers

Energy policy is an obvious case: while a hurricane moving through the Gulf of Mexico took a big bite out of domestic oil production, Biden took several steps to hamstring the domestic fossil fuel industry at a time when the economy was still recovering from the pandemic. This included revoking permits for the Keystone pipeline, a ban on drilling on federal lands and federally-controlled waters in the Gulf, shutting down production on some private lands on the pretext of enforcing the Endsngered Species Act, and capping methane emissions by oil and gas producers. And all that was apparently just a start.

As Mark Theisen notes, when you promise to destroy a particular industry, as Joe Biden has, by taxing and regulating it to death, who wants to invest in or even maintain production facilities? Some leftists with apparent influence on the administration are threatening penalties against the industry up to and including prosecution for “crimes against humanity”! This is moronic, of course, but perhaps these extremists are just trying to move the Overton Window. Fossil fuels have been and still are a miracle in terms of human well-being, and renewable (but intermittent) energy sources are simply not capable of replacing the lost power, as Germans, Californians, and Texans are learning. Furthermore, the effort to kill fossil fuels amounts to a war on the poor. Americans are facing steep increases in their utility bills and blackouts during the times when power is needed most. Now, Biden is actively trying to wheedle more oil production out of OPEC, as if it’s okay for those nations to extract it, but not for us to do so!

Labor Shortage

Have you heard it’s hard to get help these days? You’ll notice it pretty fast if you have regular occasion to deal with service establishments. Goods are getting scarce on the shelves as well. Food and paper goods are getting pricier. The semiconductor shortage has been prominent, impacting production and pricing of electronics, computers, and new cars, with a big cross-effect on the used car and rental car markets. Everywhere you look, sellers seem short of inventory. This year it might be tough to fill the space under the Christmas tree for lack of availability.

This isn’t just about cargo ships unable to unload at the ports, although that’s significant. Patrick Tyrell and Anthony B. Kim note the difficulty of overcoming the supply chain breakdowns even with 24/7 operations at the ports. Tyrell snd Kim offer this quite from the Financial Times:

“The US is facing a shortage of warehouse space and truck drivers, and shifting to 24/7 operation will require enormous co-ordination between the publicly operated ports and private sector groups, including large retailers and freight companies.”

There are several reasons for the labor shortage: a few workers and businesses might still be living in fear of COVID, especially in “blue” states and urban areas where the fear factor seems to have been more palpable. That’s where the high unemployment is. There has also been an apparent wave of retirements among late baby-boomers who were already on the cusp of hanging up their skates. However, the Biden Administration has instigated a set of ill-advised policies that blunt work incentives, leading to reduced labor force participation: the repeated extensions of pandemic-related unemployment benefits; increased child and dependent care tax benefits; the moratorium on evictions from rental property; the elimination of work requirements for expanded Medicaid coverage; and increased EBT and SNAP benefits. This is not hard to understand: if you pay people to stay home, they will stay home, even as you suffer through an interminable wait for your fast food. But there might not be a wait at Dunkin’ Donuts, because they’ve been running short on donuts due to “supply chain issues”!

Destructive Public Policy

COVID policy contributed to the early plunge in demand in 2020. Economic output declined, and ramping-up production is not always a simple thing. In this case, it was hindered by repeated non-pharmaceutical interventions and confused messaging from public health authorities. These are issues I’ve felt compelled to address too many times on my blog over the past 18 months. The negative economic effects of these policies continue to linger, and it should surprise no one.

The Democrats’ so-called “social infrastructure” bill, which looks mercifully unlikely to pass without major curtailments in scale and scope, would exacerbate many of the problems cited above. As I’ve noted recently, it’s more of an “infra-shackle” bill for the private economy than an infrastructure bill. For $3.5 trillion (an understatement based on budget gimmickry), we get heavy regulation and taxes, particularly on fossil fuels, subsidies for uneconomic technologies, assorted entitlements with no means testing, wage- and job-killing (and inflationary) hikes in corporate taxes, and other tax disincentives to private investment. The bill would represent a huge reallocation from the private to the public sector via coercion and public competition for scarce resources.

As if that wasn’t bad enough, now Biden has issued his legally dubious vaccine mandate, which has been met with outrage among many workers, from Chicago cops and other public servants, health care workers, truckers and workers at such corporate giants as Boeing, Southwest Airlines, and many others. Unions are furious. People are walking out. This represents a negative “supply shock”, an unexpected event that hinders production and boosts prices. Joe Biden looks to be well on his way to earning the title of “The Stagflation President”.

I’ll leave you with this gem from Brian Dunn:

Inflation Doomsayers and Downplayers

25 Friday Jun 2021

Posted by in Inflation, Monetary Policy

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There’s a big disconnect between recent news about escalating inflation and market expectations of inflation. In fact, there’s a big disconnect between market expectations and what we’re hearing from some conservative economists. The latter are predicting more inflation based on the recent spurt in prices and the expansionary policy of the Federal Reserve. Can these disparate views be reconciled?

Market Predictions

Market interest rates are considered pretty good predictors of inflation, at least relative to surveys and macroeconomic models. That’s because a fixed interest return is eroded by inflation, and fixed income investors will bid up interest rates to incorporate a premium to compensate for perceptions of increased inflation risk. This is known as the Fisher Effect, after the economist Irving Fisher. In fact, investors should bid rates up more than one-for-one with expected inflation, because the inflation premium will be taxed. A higher return must compensate for both higher expected inflation and taxes on the increased inflation premium.

After rising by about 1.2% from last summer through mid-March, interest rates on Treasury notes have declined slightly. The earlier run-up anticipated a strengthening economy, but if the increase was due to higher expected inflation, we could say it represented an added premium of about 1%, and that’s roughly in-line with changes in some other market-based gauges of expected inflation (ignoring pandemic lows).

Recent Inflation News

Meanwhile, measured inflation certainly has increased in 2021. I say “measured” because 1) “true” price changes are measured imperfectly, and 2) there is a difference between real inflation, which is a continuing process, and month-to-month changes in prices. Here, we’re really talking about the latter and hoping it doesn’t turn into a bad case of the former!

The green line in the chart below is the percent change in the consumer price index (CPI) from a year earlier. After declining during the pandemic, it rebounded sharply this year to almost 5% in May. The purple line is the increase in the CPI excluding food and energy prices, otherwise known as the “core” CPI. The jumps shown in the chart are well in excess of the market’s assessment of inflation trends.  

Both versions of the CPI have jumped in the past few months, but it turns out that durable goods like washing machines, TVs, and (probably) Pelotons have jumped the most sharply. Most of the weakness in prices during the pandemic was in non-durable goods, which stands to reason because so many activities away from home were curtailed. Also noteworthy about these price movements: when measured over a span of two years, prices excluding food and energy have risen at an annualized rate of only 2.6%. 

There are two other lines in the chart above that demonstrate much less alarming changes in prices: the orange line is so-called “median” inflation, which is the price change in the median component of the CPI. That is, half of all price components included in the CPI rose faster and half rose slower than the median. It has barely accelerated this year and stood at only about 2.1% higher in May than a year earlier. The blue line is the so-called “trimmed” CPI, or the average price change of the middle 84% of all CPI components. While it has accelerated in 2021, the year-over-year increase was only 2.6% in May. 

Thus, the breadth of the jump in prices was limited. The Federal Reserve and a lot of market participants insist that the uptick is narrow and temporary — a transitional phenomenon related to the sluggish recovery of supplies in the post-pandemic environment.

But again, the accuracy of price measures is always in question. For example, the housing cost component of the CPI was up only 2.2% in May from a year ago, but it is calibrated to actual survey data only twice a year, the survey is a weak data source, and we know home prices and rents have risen aggressively. Quality and quantity adjustments are always in question as well. An old approach for businesses dealing with rising costs is to reduce package size, which has been called “shrinkflation”. It seems to be back in vogue.

Inflation Drivers

It’s not yet clear how much wage pressure is occurring now. The economy-wide average hourly earnings data has been distorted over the past 15 months by the changing mix of employment, first shifting toward greater concentration in high-wage (work-at-home) occupations and now shifting back toward lower-wage jobs as the economy reopens. But we know many employers are facing a labor shortage, due in large part to extended unemployment benefits and other pandemic-related aid, so this puts upward pressure on wages. In 2021, minimum wage rates are undergoing substantial increases in 17 states, and a number of large employers such as Amazon have increased their minimum pay rates. That creates competitive pressure for smaller employers to boost pay as well.

The fundamental cause of an “honest-to-goodness” inflation is “too much money chasing too few goods”. The Federal Reserve has certainly given us enough to worry about in that regard. The basic money stock (M1) increased by four-fold in the late winter and early spring of 2020, just as the pandemic was spreading. Today, it is almost five times greater than in early 2020, so growth in the money stock remains quite fast even as the recovery proceeds. No wonder: the U.S. Treasury is issuing about $1 trillion of new debt every four-to-six weeks, and the Fed is essentially monetizing these deficits by purchasing a huge chunk of that debt.

That’s a lot of “helicopter” money… new money! But are there too few goods for it to chase? Or is it really chasing anything? Is it just sitting idle? First, GDP is likely to exceed its pre-pandemic level in the second quarter, despite the fact that private payrolls are still down by about 7 million employees. Of course, that doesn’t eliminate the ostensible imbalance between money and goods, and one might expect a veritable explosion in price inflation under these circumstances.

So far that seems unlikely. The so-called velocity of money (its rate of turnover) has plunged since the start of the pandemic, with no discernible rebound through the first quarter of 2021. That means a lot of the cash is not being used in transactions for real goods, but financial transaction volume has been quite strong in 2020-21. Daily stock trading volume was up by more than 50% in 2020 from 2019, and in the first quarter of 2021 it stood another 34% higher than the 2020 average (though volume tapered in April). This is to say nothing of the increased frenzy in cryptocurrency trading. So, while some money is turning over, the expansion of the money stock remains daunting and pressure might well spill-over into goods prices.

Caution Is a Virtue

So long as the Fed keeps printing money, and assuring investors that it will keep printing money, the equity markets are likely to remain strong. There are mixed signals coming from Fed officials, but the over-riding message is that the recent uptick in prices is largely temporary and limited in scope. That is, they assert that certain prices are being squeezed temporarily by rebounding demand for goods while suppliers play catch-up. 

Market expectations of inflation seem to agree with that view, but I have strong trepidations. There are cash reserves held in the private sector to support more aggressive spending. Large companies, consumers, and banks are still holding significant amounts of cash. The Biden Administration is doing its best to spend hand-over-fist. This administration’s energy policy is causing fuel bills to escalate. Home prices and rents are strong. The dollar is down somewhat from pre-pandemic levels, which increases import prices. Finally, the Fed is reluctant to reverse the huge increase in the money supply it engineered during the pandemic. If the recent surge in prices continues, and if higher inflation embeds itself into expectations, it will be all the more difficult for the Fed to correct. 

The market and the Fed might be correct in predicting that the spike in measured inflation is temporary. The recent data show that these worrisome price trends have not been broad. Just the same, I don’t want to hold fixed income investments right now: if higher expectations of inflation cause market interest rates to rise, the value of those assets will fall. Stock values should generally keep pace with inflation barring stronger signals of tightening by the Fed. Unfortunately, however, many would suffer in an inflationary environment as wages, fixed assets, and benefits are devalued by rising prices.