Is Inflation Haunting the Fed?

 | Apr 04, 2012 | 5:00 PM EDT  | Comments
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If unemployment is so high, why hasn't inflation fallen even further?

St. Louis Fed President James Bullard (non-voting) has been arguing that the output gap -- or slack of resources, especially labor -- is not as large as we think and inflation might come in higher than we might otherwise expect.

Structural unemployment is one consideration. Another is that we live in a global marketplace and some countries follow our easy money prescriptions on a de facto basis by currency ties (think China). Only when currencies are truly market based and flexible, and only when we measure inflation in a closed economy, can we ignore inflation in the rest of the world affecting us here.

For starters, U.S. imports were about 18% of U.S. GDP as of the fourth quarter. (Note, of course, that GDP is exports less imports, so this is not quite a correct view, but it does put things into context.) 

We also need to look at where import prices have been headed. We can exclude commodity prices and only look at core import price inflation, where we see that over the past twelve months core consumer goods prices advanced 2.3%, while core capital goods advanced by 1.1%. So far, this hasn't been too problematic, but we need to look ahead. And considering wage pressures in many emerging economies, we need to be vigilant about those labor costs, not just what U.S. workers are paid.

"The intuition is that 'dollar bloc' countries should appropriately be viewed as closely tied together," Bullard said.

Based on some existing research that analyzes open economies, Bullard said there are good reasons to think the global output gap is a relevant indicator for domestic inflation.

"This might help explain why current U.S. inflation is higher than would be predicted based on a closed economy analysis," he concluded.

There have been critics that loose U.S. monetary policy has been contributing to global inflation, which brings rising wages, abetted by rising employment levels abroad that lessen the global output gap. In advanced economies, industrial production is still roughly 8% below 2007 levels. In emerging economies, industrial production is 40% above 2007 levels.  Globally, industrial production is now roughly 15% above 2007 levels. Output, globally, may outpace the ability for some economies to continue to grow without prompting more inflation.

Bullard said it is a mistake to ignore that fact when considering our own monetary policy, with the implicit understanding that where we set rates often determines monetary policy in countries with a more-or-less fixed exchange rate to the U.S. And another issue is that, should the U.S. dollar be weaker than what it otherwise would be with tighter monetary policy conditions, certain commodity prices that are priced in dollars would be higher for some international customers and that can also fuel inflation abroad. In regions where unemployment is low, that higher commodity price inflation may be prompt wage inflation when those wages climb with broader inflation measures. Those will be reflected in the prices we pay for those goods and services.

Specifically, Bullard noted that "an alternative explanation is that the U.S. output gap is not the relevant output gap for U.S. inflation," suggesting that perhaps the global output gap is what really matters.

"The global output gap is probably much narrower or even positive; this would then be interpreted as putting upward pressure on U.S. inflation," he added.

He also said that the monetary policymakers in one country can ignore the output gap in other countries only if inflation is defined as "domestic (producer) price inflation" and exchange rates are perfectly flexible.

But "these conditions are often not met in reality," he said.

Neither condition applies to the U.S. economy. U.S. producer prices for finished goods are already in excess of the Fed's target, with core PPI for finished goods having risen by 3.0% in the year to February 2012.

So, when we consider why the Fed might not want to engage in further monetary stimulus right now, perhaps this is a good place to start. While the markets seem to be disappointed that there is no QE3 forthcoming, I wonder what might happen if monetary policy actually needs to be tightened before 2014.

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