About that inflation ‘renormalization’

This post is delayed and does not contain any news or analysis of recent news.  I have been away getting my five year old boy’s toes into the sand.  This time of year, from here, you can drive to that result.

But economists at JPM estimate the individual price detail in the March CPI and PPI releases imply that the core PCE deflator for the same month will have been down 0.09%.  Please ignore the false precision which just allows us to skip the discussion of rounding issues.

If their estimate is roughly right, and assuming away revisions (a sensible central case), then my usual chart will update as follows.

Screen Shot 2017-04-17 at 7.03.55 AMThe 12-month core inflation rate would have fallen from 1.75% in February to 1.59% in March. And, somewhat arbitrarily, the 3-month rate would be below the 12-month rate, not that I care much.

During this expansion core PCE inflation has run just over 1 ½% while headline inflation (not shown) has run just below. So inflation has been about 50 bps below the Fed’s longer-tem target, and I am not inclined to emphasize other metrics on the grounds they show higher inflation.  (To wit, inflation is 2%. To solve: which metric do we use to prove that?) 

Every time I mention this, I am forced to repeat that my point is not that the Fed needs to make up for bygones, although I would not be particularly against that. Rather, the point is that this shows that inflation can get durably stuck below target, which the Fed might want to take account of when thinking about the probability distribution for the future.  I think such thought would incline them to aim for above 2% inflation in the late cycle.

So this does further reduce the urgency for tightening, which the bond market seems to realize and price, implying there is not much to do there, particularly for an amateur not following this closely.   More fundamentally, low inflation means the Fed should continue to aim for above-trend growth and a further tightening of the labor market.

However, I admit to two complications, which make this trickier than it was. First, forcing the unemployment rate far below the estimated natural rate could be destabilizing in its own right.  It might be “better” if inflation were already drifting to target, as that would prevent the Fed from having to choose how to manage this disconnect or failure of the divine coincidence.  But I doubt the market can look around so many corners, so low inflation is probably still marginally constructive.

Second and more fundamentally, the way I interpret these data is model dependent.  Some just reject the idea that low interest rates put downward pressure on unemployment or that falling unemployment puts upward pressure on inflation. (If I am not mistaken, David Andolfatto was being tediously Socratic * on that point in a recent exchange, from which I bailed after one round. I like his work, though.)

I sympathize with their skepticism, as these relationships are not convincingly confirmed in the data. Some would say they are convincingly rejected.  I don’t have much to add to this debate. I go with what I take to be the least shitty approach, available at today’s low level of development of macro theory.

* He clearly follows the insincere compliment / rhetorical question Tweet structure, which chews up time. He did not really like how I “thought it through.” 😉