The selloff in the stock market last week was attributed by some to inflation worries — namely that persistent inflation means a reduction in the Fed Funds rate is less likely than the market had until recently believed.
Not being an inflation-follower, I was a little mystified by all this. Mystified, first, by the fact that market participants had believed a reduction in the Fed Funds rate was in the works; in this respect I am sympathetic to Ritholtz’s view expressed here. Puzzled, second, by the worries about accelerating inflation, notwithstanding the most recent raft of positive (for growth) indicators.
On this second point, take a look here:
Figure 1: Twelve month inflation rates for CPI-urban all (blue) and core (red), seasonally adjusted, calculated as log-differences. Blue square and red triangle denote implied inflation rates using Bloomberg consensus for May month-on-month inflation. “Comfort zone” highlighted in blue, NBER-defined recession dates highlighted gray. Sources: St. Louis Fed FREDII, Bloomberg, and NBER.
Although both inflation series are above the “comfort zone”, headline inflation is clearly on the downtrend. On the other hand, core CPI inflation exhibits a less pronounced trend. In addition, May’s implied twelve-month change in the CPI expected by the market (or at least those participants surveyed by Bloomberg) does not suggest a rapid move toward the comfort zone. Maybe it’s just that the market expected inflation to come down faster over the next few months.
What about inflation in the rest of the world? In the other major economies of the world — the Euro area, and Japan — inflation does not appear to be a big worry (Figure 2) Two caveats: First, core CPI inflation is rising in the Euro area, and in April was close to the headline harmonized index of consumer prices twelve month inflation rate). Second, to the extent that strong growth is projected in the Euro area into the future (and that one believes in a Phillips curve — more on that in a later post), the inflation is likely to be rising rather than falling. That would necessitate further interest rate increases that would hit at equity valuations. So that much makes sense. Still, I’m not certain the Euro area is where the action is. Rather, I think the worries are centered in some of the BRICs.
Figure 2: Twelve month inflation rates for US (blue), Euro area (red), and Japan (green), calculated as log-differences. Sources: IMF, International Financial Statistics, and author’s calculations.
Figure 3: Twelve month inflation rates for Brazil (blue), Russia (red), India (green), and China (purple), calculated as log-differences. Sources: IMF, International Financial Statistics, and author’s calculations.
This point was highlighted by Dave Schuler in The Glitterning Eye, discussing the NYT article on rising hog prices in China. In Figure 3, measured inflation in China (and India) are rising, although admittedly from relatively low levels (China had inflation rates in excess of 25% in the mid-1990s, and Russia had a bout of hyperinflation as recently as 1999).
Why should inflation in China matter for US inflation? In a free-floating rate world, it shouldn’t directly matter. But to the extent that China manages its exchange rate relative to the US dollar, the price movements in tradables there get translated to the United States via imported goods. Now, it would be a mistake to overstate this effect. Indeed Kamin, Marazzi and Schindler (RIE, May 2006) pointed out in 2004 that the effect of decreasing prices from Chinese goods reduced import price inflation by less than one-fourth of a percentage point for industrial countries (working paper version here).
To the extent that Chinese prices start to rise, on top of the slow appreciation of the RMB (in a case of “be careful what you wish for”), this inflation-mitigating effect originating from China disappears.
So, I guess that this little excursion has clarified some of my questions. Of course, the first puzzle remains (although I’m willing to entertain the idea of wishful thinking).
By the way, after writing this post up, Jim H. pointed out to me that Dave Altig at MacroBlog shares some of my mystification. Glad to be in good company…
[Late Addition: 6/11 6:40pm Pacific]
Figure 4: Twelve month inflation rates for core CPI all (blue) and core personal consumption expenditure deflator (dark green), seasonally adjusted, calculated as log-differences. “Comfort zone” highlighted in blue. Sources: St. Louis Fed FREDII.