Tuesday, March 29, 2011

Core Inflation: Much Ado About Nothing

Ryan Avent is right that we should not get worked up over the possibility that U.S. core inflation appears to have bottomed out.  A potential turn around in core inflation does not negate that fact that the demand for money remains elevated and is hampering a robust recovery in nominal spending.  In addition, forward-looking measures of inflation indicate that long-term inflation expectations remain below the Fed's implicit 2% inflation target as seen in the figure below:

 Source: Cleveland Fed
                                                
Between the elevated demand for money and below-target inflation expectations, it is hard to see why one should get excited about the recent activity in core inflation. These developments, if anything, indicate that monetary policy may still be too tight.

4 comments:

  1. DB, I think you are mistaking excess demand for money for excess demand for income! With U6 at 15%, a large number of people underwater on their mortgages, what we need is a fiscal policy bailout to help households rather than banks. Perhaps some kind of job guarantee scheme, or extensive renegotiation of mortgage contracts. I realize that this is politically unlikely, which underscores how political failure lies at the center of America's decline.

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  2. ECB,

    I would argue that excess demand for income is a problem because there is an excess demand for money.

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  3. Can't we keep us both happy ? Maybe get the Federal Reserve to purchase mortgages from banks, take the writedowns on to the Fed's balance sheet and reissue loans commensurate with the now going house prices ?

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  4. ECB makes a good point. The dramatic increase in risk asset pricing is evidence of falling liquidity demand amongst speculators. This is at odds with the behavior of households and firms. Why the divergence? After two rounds of QE, and two years of "extended period", house prices are still falling.

    The significance of falling house prices goes beyond the household wealth effect. It is one reason banks keep such high precautionary balances. It also reduces the capital and loan collateral available to would-be entrepreneurs (depressing employment growth).

    One solution: at some level of expected inflation, people will turn to housing as a hedge. We just haven't found that level yet.

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