Is a Change in the Trend of Consumer Price Inflation Looming?

Readers may recall our recent article “Inflation in the Nation”, where we commented on the recent jump in CPI to 2% annualized. As we noted, it is interesting that the economy's production structure has once again been markedly distorted by the Fed's inflationary policies, in particular, while capital goods production has revived strongly, consumer goods production has stagnated (see this chart for details). This would,ceteris paribus, favor an increase in consumer prices, or at least a shift in relative prices to the detriment of capital goods prices.

We also added a chart to a recent article by Bill Bonner, in which he discussed the growing gap between the MIT's 'Billion Prices Index' and CPI. Here is the most recent chart (unfortunately it only shows the situation up to the end of April, but the trend is clear even so):

The 'Billion Prices Index' (BPI) vs. CPI. There is now a growing gap between the two.

If we look at the history of the year-on-year change rates of the BPI vs. CPI, we can see that the former appears to lead the latter when divergences emerge (unfortunately the sample size is very small, so we have to take this information with a grain of salt).

The y/y change rates of BPI and CPI – last time a divergence was in evidence, BPI turned out to be the leading indicator.

The reason why we are discussing all this, is that Marty Feldstein recently uttered a warning in a WSJ editorial about growing 'price inflation' pressures, noting that the Federal Reserve appears to be 'behind the curve' (this is of course only natural – it always is, as it drives with its eyes firmly fixed on the rear-view mirror).

A Good Laugh at Feldstein's Expense?

A report published at Marketwatch, discusses Feldstein's warning. We certainly don't always agree with Mr. Feldstein's economic views, and we cannot say whether his prediction will turn out to be correct this time. However, something quite interesting happened after he issued his warning:

“Inflation is already rising faster than the Federal Reserve’s 2% target and presents a near-term challenge to the central bank, said legendary economist Martin Feldstein on Tuesday. Feldstein, now an economics professor at Harvard University, was in the running to replace Alan Greenspan for the top Fed spot in 2006.

In an op-ed in the Wall Street Journal, Feldstein said “the key to the future” is how the Fed will respond if prices continue above 2% annual target.

“A misinterpretation of labor-market slack, and a failure to create a positive real federal-funds rate, could put the economy on a path of rapidly rising inflation,” Feldstein wrote. Feldstein said the Fed’s rhetoric on inflation makes him worry that the central bank “may not react quickly and aggressively enough if inflation continues to rise above 2%.”

His views were greeted with some derision, like this tweet from Mark Thoma, a professor of economics at the University of Oregon.

(Surprise!!!) Warning: Inflation Is Running Above 2% – Martin Feldstein http://t.co/40ZQDkrOnc

• Mark Thoma (@MarkThoma) June 10, 2014

We don't know anything about Mark Thoma, but it seems to us that his derisive tweet is symptomatic for the currently quite widespread consensus that 'inflation is not a problem'. In fact, if anything, most economists are worried about 'inflation being too low', or are even fretting over the alleged 'threat' of deflation.

As Janet Yellen's reply to a question by Marty Feldstein on occasion of a recent appearance of hers reveals, this is also the consensus view at the Fed:

“Feldstein pressed Federal Reserve Chairwoman Janet Yellen on how the central bank would respond to higher inflation during her appearance before the New York Economic Club in April.

The Fed chairwoman replied “the risk is greater that we should be worrying about inflation undershooting our goal and getting inflation up to 2%.”

She added that the Fed “absolutely will be committed to protecting inflation if it threatens to rise persistently above 2%.”

As our readers know, our thinking about inflation is quite different from the mainstream's. To us, the term inflation is the designation for an increase in the money supply. Rising consumer prices are just one of many possible effects of money supply inflation, and the question of if and when money supply inflation will lead to rising consumer prices mainly depends on contingent circumstances. The only thing that is absolutely certain is that money supply inflation leads to a 'price revolution' across the entire economic system, as it leads to massive distortions of relative prices (which is incidentally the main reason why capital goods production has boomed while consumer goods production has stagnated).

So, is there an 'inflation problem'? Indeed, there is.

The 'inflation problem' illustrated – click to enlarge.

However, central banks only react to inflation if and when it begins to impact CPI. Should Mr. Fedlstein's forecast turn out to be correct, it will certainly surprise the socks off a great many people. It would also be anathema to the current bubble in financial assets, as this bubble is predicated on the idea of administered interest rates remaining at zero for as far as the eye can see.

Conclusion:

When warnings about inflation meet with ridicule, it may actually be a good time to take them seriously.

charts by MIT, St. Louis Fed