How long should we expect high inflation?

There was bad news on the inflation front this week, with the CPI rising 6% over a year ago.  We have not seen 6% inflation in 30 years.  This is a worrisome development for those on fixed incomes, as well as for those whose income growth fails to keep pace with inflation.  

The consensus among economists is that the current inflation is a classic case of too much money chasing too few goods.  Compounding the problem is the covid-induced shift in demand from services to goods.  

Economic history suggests one of two alternative scenarios will play out.  One possibility is that the inflation will prove to be temporary, just like it was in the aftermath of World War II.  In that case there was pent-up demand for everything (many goods were rationed during the war) along with the need to shift the economy away from tanks and aircraft carriers toward housing and education.  Option B: a replay of the 1960s and 1970s, when a vicious circle developed with rising prices feeding into higher wages, which in turn increased costs even more requiring even higher prices.  

Jerome Powell, Janet Yellen and other White House and Fed economists say inflation will be temporary.  Companies will need a few more months to ramp up supply, but once that happens we will be down to 2-3% annual rates.  But not everyone is buying this!

Two clues about the future direction of inflation can be found in the bond market.  First look at the actual yields for five-year and ten-year bonds, which are 3.1% and 2.7%.  Interest rates adjust upward in response to expected inflation, so these rates indicate that the bond market does not expect inflation above 3% over the next five years.  

The second clue: the Treasury sells two types of bonds: those with a fixed yield and those where the yield is indexed for inflation.  Adjusting for maturity, a comparison of the yields tells us what financial markets expect.  So take a look at this chart from the St Louis Fed.  At the beginning of the year, the yields implied an expected inflation rate of 2%.  From March through September, the expected inflation rate increased to 2.5%.  Now it is up to 3%.  

My advice: keep an eye on the bond markets in the months ahead.  

Feldstein on inflation risk

Great article by Harvard's Marty Feldstein on the pressures facing the Fed to stimulate the economy while keeping inflation in check.  The Fed has flooded the banking system with liquidity.  So far banks have sat on their excess reserves and received 0.25% interest from the Fed.  But at some point, Feldstein argues, banks will start loaning these funds out to households and businesses.  Even though unemployment remains over 8 percent, Feldstein is concerned about capacity constraints. 

Half of the unemployed have been out of work for a year or more; there is a significant risk that the long-term unemployed will not be reabsorbed into the labor market very quickly.  Feldstein's fear: the unemployment rate gets stuck at 7.5 percent, causing Congress to press the Fed to keep the stimulus going at a time when all the excess money in circulation starts leading to higher prices. The Fed has never injected this much liquidity into financial markets before; will the Fed know when and how to remove the excess liquidity?

Cry for Argentina's economists

Argentina has an inflation problem.  Economists and business experts recognize that inflation, if measured using standard techniques, is well above 20%.  The Argentine government (which stands for election this year) is not comfortable with this fact.  The official agency in charge of inflation statistics has been politicized since 2007; the official statistics claim the inflation rate is "only" 10%. 

Last week WSJ reported that the situation has escalated.  The Argentine government brought charges against consulting firm MyS Consultores for "publishing false information about inflation data;" jail sentences could result.  At least nine other firms already have been fined $122k each for publishing their own (presumably more accurate) inflation data. What makes the situation even more bizarre is that some Argentine provinces publish their own inflation data and their numbers also cluster in the 20% plus range. 

The fines and prosecutions presumably are intended to discourage honest reporting of inflation in the months before the October election.  I never thought that the basic calculations of inflation that all students of economics master in their first course could result in a fine or jail term.

Corporate America fighting obesity by shrinking serving sizes

Well not exactly.  Today's NYT (now a paysite, so there will be fewer links) discusses how food portions in the grocery school are shrinking.  The motivation is not the obesity epidemic; instead it is the rising cost of many raw materials.  Fearful of raising prices and losing market share, companies are reducing the number of saltines in a box, the number of ounces in an orange juice container, and the size of the can for fruits and vegetables. 

But wait, there's more good news -- the smaller packages use less material and thus have a smaller carbon footprint. 

Why is this happening -- I say it is a combination of economics and psychology.  Business school professors weigh in:

“Consumers are generally more sensitive to changes in prices than to changes in quantity,” John T. Gourville, a marketing professor at Harvard Business School, said. “And companies try to do it in such a way that you don’t notice, maybe keeping the height and width the same, but changing the depth so the silhouette of the package on the shelf looks the same. Or sometimes they add more air to the chips bag or a scoop in the bottom of the peanut butter jar so it looks the same size.”

Thomas J. Alexander, a finance professor at Northwood University, said that businesses had little choice these days when faced with increases in the costs of their raw goods. “Companies only have pricing power when wages are also increasing, and we’re not seeing that right now because of the high unemployment,” he said.

 Any link to quantitative easing by the Fed is purely coincidental.   Or is it?

Hidden food price inflation?

Food price inflation was a mere 1.5 percent over the past year, according to the Consumer Price Index.  Prices for food items consumed at home rose 1.7 percent, whereas the inflation rate for food consumed away from home was 1.3 percent.  

A recent N&O story pointed out something that friends and family had been noticing for some time: smaller food containers, but no change in price.  For instance some cans that used to be 16 ounces are now 13 (ProPlan Adult) or 14.5 (DelMonte tomatoes) ounces.  Consumer Reports has also done a study on this; they find smaller packages for orange juice, ice cream, dishwashing liquid, paper towels and toilet tissue.  In each case the package is now 10 percent smaller or more. 

I have yet to see a serious study by an economist into whether the Bureau of Labor Statistics has been asleep at the switch.  The most recent CPI press release does show increases in the prices of household paper products (6 percent) and ice cream (4.5 percent) but not much change in other categories. 

How is that QE2 thing working out for you?

Fed announces aggressive plan to buy long term bonds to lower long term interest rates and stimulate the economy.  Contrary to expectations, fears of inflation lead to slightly higher long term interest rates.  Don't pull on Superman's cape and don't mess with the bond market.

Bond buyers think inflation will rise

Yesterday the U.S. Treasury sold a five-year $100 bond for $105.50.  Are people knowingly paying the feds to borrow money from them?  No, markets have not gone completely insane.  Today's NYT reports that these are TIPS (Treasury Inflation-Protected Securities) bonds, which guarantee that the principal will not be eroded by inflation.  This is done by indexing the $100 to the Consumer Price Index.  Compared to the yield on regular bonds, the market is in effect signaling that it expects inflation to rise over the next five years and is willing to pay a premium to hedge against that risk. 


NYT also reports fears that the Russian drought and extreme weather in the U.S. corn belt will shift food prices upward over the next few months.  With the Fed expected to buy more long-term bonds in the coming months, are we looking at a replay of the 1970s with high inflation AND high unemployment?

Cry for Argentina

I am taking 16 NC State MBAs to Argentina and Chile later this month to learn about the different environment facing businesses in those two countries. This week's Economist magazine has an outstanding piece about Nestor and Cristina Kirchner, the husband-and-wife team that has run Argentina since 2003. Out of control spending. Corruption. Inflation. Punitive taxes and price controls. Confiscation of private pensions. Alas, Argentina has seen this play before and we all know how it will end.

When will the Fed start raising interest rates?

We will be talking about the Fed in MBA 505 this coming week. The big question right now, according to this recent WSJ article, concerns when will the Fed start raising interest rates. The fed will be looking at GDP, unemployment and inflation signals. Before raising rates, the Fed is likely to send out signals weeks, if not months, in advance. Next year's midterm Congressional elections will not make the Fed's job any easier. It is quite possible that the Fed will need to raise rates some time in 2010 to defend the value of the dollar and send a strong signal about its commitment to fight inflation even though unemployment is likely to be 8-9 percent when the rates start going up. Congress may choose to challenge the Fed's independence in such a situation.

Falling behind in higher ed

I had been thinking about writing a piece on the value of higher education, but Peter McPherson, former president of my undergraduate alma mater Michigan State, and David Shulenburger have saved me some work in today's WSJ op-ed. Key points:

In Japan, Korea and Canada, more than 50% of young adults hold college degrees. Only 41% do in the United States.

The more educated a work force is the more value it adds to society. ... Since 1980, the gap between the earnings of those with bachelor's degrees and those with just high-school diplomas has widened. The ratio between the median earnings of men with the former and men with the latter grew to 1.99 in 2007 from 1.43 in 1980.

McPherson and Shulenburger argue that the US should set a goal of 55% of young adults with college degrees by 2025. Not sure that's the right number, but this is a discussion that we need to have, especially in light of all of the cuts in education funding that are taking place around the country. We will become a relatively poorer country if we do not figure out how to generate a higher percentage of young adults with college degrees.

The authors may be a bit too eager to let financing from the federal government play a key role in expanding access. Part of the debate needs to focus on access to higher education in terms of mode of delivery and cost. Tuition has tracked all too close to health care in terms of rising costs over the last 20 years. It is hard to see how we will make much progress on access to higher education without paying some attention to the cost side of the equation.