CPI trending higher, NGDP growth lower – monetary policy must go easy

A James Alexander post

The echoes of 2008 became stronger last week as both headline and core US inflation as measured by the CPI rose faster than expected. It is a very dangerous cocktail when the claque sees inflation yet nominal growth expectations are weak. It caused the Great Recession when central banks misread the situation. Hopefully they will have learned their lesson, but the current tightening bias of the Fed doesn’t give us much confidence.

Go to Twitter and enter “core CPI” and you’d see a welter of inflation hawks trumpeting the now clear upward trend in CPI. These were typical:

“John P. Hussman‏@hussmanjp

Not to bust anyone’s NIRP bubble, but while YOY CPI inflation is 1.34% due to food & energy, YOY core inflation rose to 2.22% in January.

Michael Ashton‏@inflation_guy

I did NOT realize until just now that this month’s 0.29% rise in core CPI was the highest m/m since 2006.

Carl Quintanilla‏@carlquintanilla

Beating estimates in past 2 wks: * core CPI * core PPI * hourly wages * retail sales * Ind. Prod


It is hard to disagree with the charts over the short-term.


The longer term is a bit different, of course.


But does it mean the Fed should take act? The markets decided the new information content from the CPI data was virtually nil.

Why were markets so calm?

 1. The Fed looks at the far superior Personal Consumption Expenditure price index or deflator. It is composed of the dozens of individual price index estimates used to deflate nominal spending to derive a supposedly “real” level of spending for each category of goods and services purchased. Compiling these indexes is a task fraught with pitfalls. At least PCE uses actual data on expenditure rather than the CPI surveys of consumer expenditure as a starting point. It also includes items bought on behalf of consumers by their employers like healthcare and insurance. It also estimates the financial benefit of services not paid for, like banking.

PCE has historically run 0.5% lower than CPI and been far less prone to volatility. The PCE deflator much more quickly captures substitution effects, as consumers switch purchases from higher priced goods and services to lower ones, or like today (probably) switching spending from energy and goods sectors in deflation to housing, healthcare and education – increasing the pace of service sector inflation? Looking just at the service sector will be very misleading.

The housing element of CPI remains a minefield as Kevin Erdmann constantly reminds us. Artificial shortages abound and have significant effects. Artificial demand in education thanks to state-subsidised loans  also leads to price pressure, and we all know about restrictive practices in medicine.

 2. The Fed has made it clear since the market turbulence that it caused will be incorporated into its future actions.

 3. Nominal growth is still horribly weak. Core CPI may be trending up but nominal Personal Consumer Expenditure, i.e. not deflated, remains stuck in a 3% trend – down from the 4%-5% trend achieved towards the end of QE3 when nominal spending peaked at 4.96% in August 2014.

 I remain unconvinced that PCE will move up meaningfully towards any higher trend in CPI. Nominal growth, historic and expected, remains just too low. And, of course, active monetary policy is clearly biased towards tightening.

And here we may get a horrible echo of 2008 where nominal growth expectations are flat or falling but the claque of inflation hawks is fretting about cost-push inflation. The Fed should ignore the claque and laser-lie focus on nominal growth expectations, but will they?

The other echo of 2008 comes from the accounting identity that if inflation really is rising and nominal growth really is weakening then the counterpart has to be in weakening RGDP and weakening productivity. And this is precisely what we are seeing. RGDP is weak and so is productivity.

I am a bit more more sanguine about productivity, even if arithmetically it is shown to fall. It may not be falling as the deflator may be too high, underestimating real growth, and thus productivity growth. Why is this?

First, because it is so fiendishly difficult to directly measure productivity, especially in our service-sector dominated world. There are hardly any detailed temporal or cross-border studies of productivity by industry segment, just windy, useless, macro level stuff by country. Output of physical stuff is relatively easy to measure in both nominal and real terms, as long as the quality of the stuff doesn’t change too much: a bushel of wheat, a barrel of oil, a table. But think of a college degree, a cable subscription or a visit to the dental hygienist and things get trickier.

Quality issues are very, very tricky to gauge. It should be for economic historians and politicians to argue about the quality of the nominal growth, the balance between real and inflation within the nominal figure.

Second, it will have got very difficult with the rise of the web to really figure out what is happening to the real economy. It is important to figure it out, but is really hard. Diane Coyle wrote this thought-provoking piece on Digitally Disrupted GDP recently:

 Digital technologies are having dramatic impacts on consumers, businesses, and markets. These developments have reignited the debate over the definition and measurement of common economic statistics such as GDP. This column examines the measurement challenges posed by digital innovation on the economic landscape. It shows how existing approaches are unable to capture certain elements of the consumer surplus created by digital innovation. It further demonstrates how they can misrepresent market-level shifts, leading to false assessments of production and growth.

Third, we think it will rise once the nominal economy begins to run hot again. Why should businesses invest to economise on labour when labour is so plentiful? Why should businesses invest when sales are so weak and expected to remain so?

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