The Inflation Paradox at the End of 2013

The latest inflation numbers are out from the Bureau of Labor Statistics and they show that consumer prices barely increased over the past twelve months.  The most commonly-cited measure of consumer prices is the CPI-U, the Consumer Price Index for Urban consumers.  The CPI-U is up 1.2% over the twelve months through November, and this is almost identical to the 1% 12-month rise in the data through October.  The other major inflation measure, the Personal Consumption Expenditure index (PCE), is even lower because housing is a smaller component of PCE than CPI

One of the key variables that the Federal Reserve cites in their decisions about whether or not to continue Quantitative Easing is that these inflation numbers are too low.  The Fed is targeting core inflation in the 2% range.  Inflation below this level suggests an anemic recovery.  Core inflation is the CPI-U without energy or food.  The Core CPI is up 1.7% over the past twelve months, the same gain as that over the twelve month period through October.  PCE core inflation is lower.  Despite record low interest rates and the Fed’s bond buying program known as QE, inflation seems to be low and stable.

There are plenty of news stories observing that inflation is well below the level that the Fed wants to see before reducing the economic stimulus, but why does the Fed seek inflation?  Inflation in prices indicates growth in demand for goods and services that exceeds supply.  When demand increases faster than supply, prices rise.  For this reason, rising prices in the inflation numbers suggest that the economic recovery is underway.

Inflation also encourages people to purchase goods and services rather than deferring these purchases into the future.  Higher inflation means that the buying power of cash decays more quickly in time, encouraging purchases, which in turn leads to more hiring as businesses try to keep up with demand.

Low interest rates should, in theory, result in higher inflation by making it cheaper for consumers and businesses to borrow money.  Consumer borrowing funds more purchases.  Businesses borrow to expand and hire.  More hiring reduces unemployment, increasing the number of potential consumers who are bidding against each other for goods and services.

The Fed’s impact on housing prices is clearly evident.  Housing prices have recovered smartly from their lows in 2008, largely thanks to low interest rates.  U.S. house prices are still far below the levels attained in 2008, however.  Nationally, housing prices are roughly at the same level as they were in mid-2004.  This, in turn, means that there are many homeowners who purchased homes between 2004 and 2008 that are worth less than what they paid.  To the extent that these homeowners hold mortgages, many have an overhang of debt from owing more on their houses than the houses are worth today.

The very low inflation rates that we are seeing clearly suggest that demand for goods and services in the United States is growing very slowly.  In light of the very low costs of borrowing, this is even more striking.  Either American’s cannot borrow or don’t want to borrow, and neither of these is a good sign for economic growth.  People may not be able to borrow because they can’t qualify for loans as a result of either large debt burdens, low incomes, or both.  People who could qualify for loans may choose not to borrow due to uncertainty about their future earnings and the economy as a whole.

Now we get to the paradox of low inflation.  If the economy is basically stagnant, as evidenced by very low inflation, why has the stock market risen so much?  In theory, stock prices go up because earnings go up and expected earnings growth rises.  Higher earnings reflect higher sales and production, which in turn drive prices of raw goods and labor upwards.  Higher costs of raw goods and labor are seen in higher inflation numbers.  This year, we have seen low inflation but soaring stock prices.  Rather than higher stock prices being driven by higher earnings, we are seeing an imbalance between demand and supply for stocks.  More buyers relative to sellers translates to higher prices.  Why are so many people putting money into the stock market?  One reason is that the low interest rates mean that they can refinance their homes, lower their monthly mortgage payments, and have more of their income to invest.  Another reason for rising stock prices is that more conservative investments provide so little in return.  When CD’s and short-term Treasury bonds provide almost no yield, you have to move your money to higher-risk assets if you want more return.

Low economic growth and low inflation can also co-exist with a massive bull market when big institutional investors such as pension plans have to invest more aggressively in order to meet their return targets.  These investors have specific levels of return that they are expected to meet.  In general, these return targets are high enough that the very low current yields on bonds push pension fund managers to invest in riskier assets such as stocks and hedge funds.

Where does all of this leave us?  The Fed seems likely to keep rates low because of the anemic economic growth evidenced by the inflation numbers.  Low rates drive market prices of risky assets upwards.  Ultimately, however, the slow recovery has to become more evident in earnings and this is when we can expect some equilibration in market prices to reflect a less robust economy.  This process is very hard to time, however, and a great deal will depend on market psychology.  For the time being, momentum holds sway, with investors chasing the stock market’s recent high returns.  Janet Yellen has explicitly stated that it is not part of the Fed’s mandate to try to manage the potential for stock market bubbles.  The Fed will not raise rates to cool the capital markets.  As long as inflation remains this low, we can expect the Fed to keep interest rates low.  The prices of assets such as stocks and homes will ultimately have to adjust on their own, as they did in 2008.

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