Wednesday, February 16, 2011

The threat of inflation

Headline news today: “Core producer prices rise at fastest rate in two years”.

Market reaction: “This may force the Fed to reconsider its position that inflation is not a serious threat this year,” said Michael Woolfolk, analyst at BNY Mellon Global Markets. “While the Fed can brush aside upside surprises to headline inflation, it cannot as easily brush aside upside surprises to core inflation.” (FT)

Now, some perspective. Core PPI grew at an annual rate of 1.6% in January. During the recession the PPI was in deep deflationary territory, falling from 205 to 170 (17%). Since the Fed began to the money supply, PPI has “recovered” into very low single-digit growth.

However, all measures of inflation are currently under 2%: CPI, core CPI, PPI, and core PPI. Core CPI has not been this low since the New Frontier. There is no reason for the Fed to reconsider its position that inflation is not a serious threat this year. The Fed continues to undershoot its inflation and employment targets.

The good news is that, due to quantitative easing, the money supply (M2) has begun to grow again at a comfortable (and non-inflationary) annual rate of 5%. We are in recovery, and monetary velocity has begun to rise modestly (1%). The combination of 3% real growth (let’s hope) and 2% inflation would get nominal GDP growth up to 5% (from minus territory in 2009). 6% would be better, but I will settle for 5%.

The impending departure of the hawkish Kevin Warsh from the Board of Governors and the FOMC is a good thing, in the sense that hopefully the president will nominate a more dovish governor who would be more supportive of Bernanke’s efforts to grow nominal GDP. Hopefully, Warsh won’t start testifying before Ron’s Paul’s committee about the danger of inflation.

Please note that, in all the debate about the US’s growing debt/GDP ratio, a missing fact is that one of the best ways to stabilize this number while the US is still in AAA territory is to grow nominal GDP. Growing our way out of debt is much less frightening than defaulting our way out of it. That was one thing that both Ronald Reagan and Bill Clinton understood.

Tuesday, February 1, 2011

ECB halts bond purchases: Why?

The European Central Bank bought no government bonds for the first time since October last week, reflecting growing market confidence that policymakers are
getting on top of the euro zone debt crisis.

Analysts said the ECB's move was a reflection of the better
debt market conditions and its hopes that Europe's rescue fund,
the European Financial Stability Fund, would take over its
uneasy role of debt buyer of last resort.

"It further reinforces Trichet statements that the ECB is
present in the market commensurate to the strains they see. The
ECB has clearly looked at the situation and decided that the
situation is not as pronounced as it was last month," said RBS
economist Nick Matthews.

"It is also occurring against a backdrop where the ECB
appears to be supporting an enhanced role for the EFSF which
could see the EFSF becoming the vehicle to buy bonds rather than
the ECB."

Here is my take on what may actually be happening. There has been a tug-of-war between the ECB and Germany over the size and scope of the EFSF. The ECB does not want to become the de facto bailout fund for the peripheral eurozone members.

It may be that this decision to stop buying government bonds is political and not financial. This is the best way for the ECB to pressure the European Commission to make the EFSF more credible, in that hope that markets will calm down, or in the hope that the bonds that the ECB has bought don’t go bad.

We will see if I am correct pretty quickly.