Wednesday, April 16, 2014

The Fed & Inflation
Janet Yellen, “The Fairy Godmother of the Bull Market,” may soon have to deal with an age-old adage: “Beware of what you wish for, because you just might get it.” She might have to explain why the Fed’s goal is to inflate the inflation rate back to 2%. She obviously wants to avoid deflation. Consider the following:

(1) CPI inflation rate upticking. March data released yesterday showed an increase in the CPI inflation rate to 1.5% y/y from 1.1% the month before. It was led by food prices and rents. The former rose 0.4% m/m, and 1.7% y/y.

(2) Rent inflation rising.The CPI rent of shelter component rose 0.3% m/m, and 2.7% y/y, the highest reading since March 2008. This is a very odd measure indeed. It accounts for 32% of the total CPI. It has two major subcomponents, namely tenant rent and owners’ equivalent rent (OER). The former, which reflects actual rent paid by actual renters and accounts for 7% of the CPI, rose 2.9%, and has been hovering around this rate for the past 10 months. The latter, accounting for 24% of the CPI, has increased from 2.2% six months ago to 2.6% during March.

OER is an imputed measure of the rent homeowners would have to be charged to rent the homes they own. I kid you not, though I’m sure you knew that already. Presumably, it is based on actual tenant rent. Nevertheless, the recent leap in the OER inflation rate obviously can’t be explained by a similar jump in tenant rent inflation.

This oddity is one reason why the Fed prefers to use the personal consumption expenditures deflator (PCED) as a better measure of consumer price inflation. Both rent components are in the PCED too. However, the overall weight of rent of shelter is only 15% of the PCED, with tenant rent at 4% and OER at 11%.

(3) Inflation mandate needs explaining.It’s not obvious to me why the Fed’s commitment to boost inflation is a good thing, especially if inflation is led by higher food prices and rents. We doubt that will stimulate economic activity by causing consumers to buy food and rent apartments before their prices go higher. On the contrary, the rising costs of these essentials reduce the purchasing power of consumers.

Inflation-adjusted average hourly earnings in private industry (using the overall CPI to deflate this measure of wages) fell 0.2% m/m during March. It is still up 0.5% y/y. Tenant rent inflation has been outpacing wage gains since September 2011.

Despite March’s uptick in the CPI inflation rate, we believe that there are powerful deflationary forces offsetting all the monetary stimulus provided by the major central banks of the world. Since the start of 2009, the assets on their balance sheets have increased 78% by $6.2 trillion--at the Fed ($2.3 trillion), ECB ($0.4 trillion), BOE ($0.3 trillion), BOJ ($0.9 trillion), and PBOC ($2.3 trillion).

If anyone had predicted five years ago that this would happen and that the major central banks would be worrying about the possibility of deflation rather than hyperinflation, few would have believed such a ludicrous prediction. Yet here we are, with all the models used by macroeconomists at the central banks to predict inflation clearly not working.

Microeconomic models seem to be more useful in explaining why this is happening. Globalization has made markets more competitive and reduced the pricing power of firms. Technological innovations are inherently deflationary as they boost the productivity of both labor and capital. Instead of "hypering" inflation, ultra-easy monetary policy has funded the development and implementation of deflationary technologies. Easy money has also funded the fiscal excesses of governments that often expanded capacity to provide jobs even if the demand fundamentals didn’t justify such expansion.
(Based on an excerpt from YRI Morning Briefing)

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