Jerry Bowyer | Posted: Apr 14, 2021 11:39 AM
Ramesh
Ponnuru and David Beckworth recently took to the New York Times op/ed
page to clip the wings of inflation hawks. I certainly have no
problem with ruffling the feathers of the perma-hawks -- I've spent much of the
past two decades talking people down from various inflation scares -- but
the case that inflation risks are rising is stronger than it's been in a long
time (with the possible exception of 2009, when I was briefly hawkish, and when
we did see a brief inflation spike). Let's lay out their points one by one.
1. Some
high-profile thinkers, notably Harvard Economist Larry Summers, are concerned
about inflation.
RESPONSE:
When lifelong Keynesians such as Summers voice inflation fears, we should all
listen carefully. Summers is aligned with the party in charge at the moment,
and so has political reasons to downplay the risk of inflation coming from the
monetization of high levels of borrowing and spending. When someone argues
against his natural philosophical tendency and against his tribe, we should not
be dismissive.
2. They
should relax.
RESPONSE:
Telling Summers to relax is, well, dismissive.
3. Inflation
"hasn't spiked yet." (The NY Times article was published on Feb.
17th.)
RESPONSE: Inflation
hadn't spiked yet as of Feb. 17 when the article was published, but within
three weeks of that article a number of inflationary metrics did spike on a
month-over-month basis. Month-over-month changes are important because they
take out the false assurance of last Spring's deflationary episode. Deflation
followed by higher-than-average inflation may average out to something looking
like stability, but it isn't stability and that's why looking at higher
frequency month-over-month changes can capture changes in trend better than
glomming together a whole year's worth of data.
4. For this
reason, hawks have focused on the spread between inflation protected treasuries
and regular treasuries.
RESPONSE: I
suppose some hawks have depended on the TIPS spread to make their case, but
that is not the only market metric signaling inflation. One can also look at
gold prices, foreign exchange rates, inflation-hedging funds, and nominal
commodity prices. Also the suggestion that hawks chose TIPS spreads for the
purpose of buttressing their prior commitment to the hawks flock
(ornithologically known as a "cast" or a "kettle"), may be
fair, but does that accusation not fly in both directions? I've followed Mr.
Ponnuru's work enough to see at least a suggestion that he is a long-term
member of the dove flock (aka the "dule"). From where I sit, the dual
between "dule" and "cast" is to some degree a matter of
castes. Each hovers in the sky looking for specific strands of data to use to
weave their respective nests.
5. But hawks
are wrong to do argue from TIPS spreads, because that metric is focused on CPI,
and the Fed targets a different inflation metric, PCE inflation.
RESPONSE:
Analysts of whatever flock are not wrong to look at TIPS spreads. All data has
its limits, but the fact that this particular instrument focuses on a slightly
different inflation metric than the one the Fed relies on is fairly trivial
since the two different inflation metrics are tightly correlated. If the
Treasury offered a bond tied to PCE, that would be a slightly better tracker of
the metric which the Fed tracks, but they don’t. And why don't they? Because
that's the way that people wanted it. As a consumer, I would like the inflation
of the whole basket, which CPI tracks, as opposed to changing the composition
of the bucket when ground beef gets too expensive and I buy ground turkey
instead. I’d prefer it if the Fed evaluated itself against CPI, which is a
tougher judge.
6. CPI
inflation tends to be higher than PCE inflation.
RESPONSE: If
CPI runs hotter than PCE, all the more reason to track CPI rather than let the
Fed grade itself by only evaluating the metric which is more forgiving of
monetary excess. The choice of an inflation metric which is easier to fulfill
is a reason to be concerned, not to relax. It amounts to a situation in which
the Fed can debase currency more and still give itself a passing grade because
PCE is not above 2%, even if CPI is (by their own admission) likely to be
higher. Targeting PCE gives the Fed a fudge factor of about 1/3rd of
a percent on average; the fudge factor is larger when inflation is
higher.
7. We cannot
trust a spread based on treasury bonds because the Fed buys treasury bonds and
this distorts the yields.
RESPONSE:
This topic is complex and requires separate treatment. There is significant
merit to this argument. The Fed does manipulate bond prices which introduces
political noise into the market signal. However, the argument is fairly
selective: the Fed distorts both the nominal treasury market and the inflation
protected one. So telling us that rates are manipulated doesn’t automatically
mean that inflation risk is being overstated. In point of fact, there are
technical aspects of this which are helpful to the dules but also somewhat
helpful to the casts, but probably mostly the former. A fairer approach would
look at both. We've taken a deeper dive into this
mind-numbingly technical debate in a separate article.
8. The
spread is implying an inflation rate which is below the Fed's target.
RESPONSE: If
the real spread puts inflation below the Fed's target, that is important, and
does have merit. The adjusted spread does have a high correlation with future
inflation, but not a perfect one. It has its blind spots and it just so happens
that its blind spots historically coincide with some of the conditions we see
right now. More on that in a separate piece. In addition, when the Fed thinks
inflation will be low, is that not inherently risky, because that allows it to
give itself permission to do what's easy, to spike the punchbowl even more?
9. The
Survey of Professional Forecasters is predicting inflation of roughly 2%.
RESPONSE:
That matters, but your argument suggests that markets know more than experts,
and markets are predicting higher inflation than that.
10. The
Cleveland Fed's ten year forecast is also subdued.
RESPONSE:
Seems like a hawkish sign to me. When Fed is nonchalant about inflation risks,
we should be ‘chalant’. If the Fed expects low inflation, it will be more
likely, rather than less likely, to excessively expand money supply. If they
were more worried about inflation, I’d be less worried about it.
11. The Fed
itself doesn't forecast hitting its inflation rate for at least ten years.
RESPONSE:
See point 10.
12. When
investors are frightened or uncertain, they tend to buy treasury bonds, which
lowers yields.
RESPONSE:
Yes, risk-averse climates cause investors to buy treasury bonds, but TIPS are
treasury bonds too. What needs to be shown in order to discredit the predictive
power of the spread is to show that frightened investors are distorting the
yield of one type more than the other. In terms of default risk, both types of
treasuries are the same. So they are both havens against default risk in scary
times.
13. Some
commentators wrongly predicted high inflation ten years ago.
RESPONSE:
The fact that some wrongly predicted inflation ten years ago is pretty
tangential. Some wrongly predicted non-inflation in the '70s. If the argument
is an argument from authority, then perma-dules are in a pretty weak position.
For my part, I prefer arguments from evidence over discrediting the source of
the predictions. Though I certainly have had my fill of macro-economic
frighteners. For more on this, please refer to the "supply versus supply"
debates between supply-siders in the mid oughts at National Review Online. I
have certainly been wrong sometimes, but perma-hawk I am not. Consider me more
of a mockingbird, one who changes his song as circumstances warrant, in order
to feather my nest.
14. Low
inflation, such as below 2% annual rates, can be a problem.
RESPONSE:
Perhaps there are some sectors which need inflation above 2% PCE, but what
about the rest of us? Near zero interest rate policy and an environment in
which inflation becomes a permanent part of our planning regime seems to hurt
almost all of us as savers and consumers and taxpayers, to the benefit of some
of us.
15. The
economy needs not just real GDP to grow, but nominal GDP to grow as well, i.e.
it needs inflation because certain contracts have the need for such inflation
built into them.
RESPONSE:
The argument needs more detail. Which specific contracts require the nominal
growth of at least 2% inflation to function properly? I understand that our
economy, with its various price floors -- especially in labor markets --
handles deflation badly, but that does not mean that we need plus
2% inflation. Also, most contracts seem to possess cost of living adjustments
or interest rates tied to various benchmarks which can move freely. Further, a
number of tax-bracket cut-offs and tax calculations are still not indexed for
inflation, which means inflation raises taxes.
16. The Fed
hasn’t done enough yet.
RESPONSE:
Expanding the balance sheet 130% in one year isn’t enough? Pushing Fed Funds
rates to near zero isn’t enough? Double digit money supply creation isn’t
enough? I think that given the historically extreme actions of the Fed, that’s
a real uphill climb to tell us that it needs to do more.
17. The real
danger is the inflation hawks themselves. The reason is not specified, but the
suggestion is that they will influence the Fed to not be sufficiently
inflationary.
RESPONSE:
Are the hawks really a threat? The argument so far has been that almost all the
forecasters are doves. The Fed itself has a dovish outlook. Almost no one in
Washington is calling for rate hikes (at least no one with any pull). The
fiscal outlook is rising debt, which makes us more or less addicted to easy
money. Even the markets want easy money, throwing taper tantrums at mere rumors
of even minimal monetary restraint. Even big names at the flagship conservative
opinion journal are telling us that we should all relax about inflation. Seems
like the dule is ruling the roost, while the cast issues plaintiff cak-cak-cak's
and kiks (Cooper's Hawk Sounds, All About Birds, Cornell Lab of
Ornithology) from far away.
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