Prerequisites for lower inflation
The debate is not whether inflation will ease, but by how much? Does it return toward the Fed’s 2% target or persist at 3-4%, or more?
Canada and China PPI (YoY) and FX (YoY) against the US$
In the short-term, there is probably some relief: the dollar has strengthened against key import partners and producer price indices in those countries are moderating.
The dollar cannot rise indefinitely due to rising current account strains — it will require larger and larger financial inflows — and deviations from PPP — it will be less and less attractive for foreigners. Longer-term, the factors below are a few criteria for a sustainable reduction in inflation:
(1) Headline inflation should be below other measures of inflation.
Source: Dallas Fed; own calculations
Trimmed-mean measures of inflation have been shown to be more informative than “core” inflation readings (which exclude food and energy prices) and more predictive in US, Eurozone, Japan and Australia. Research by the Dallas Fed shows that when headline inflation readings exceed a trimmed-mean measure, inflation usually broadens out (and rises) in the subsequent year. The intuition might be that firms pass on higher commodity input costs with a lag.
(2) Broad money growth needs to slow.
Source: Federal Reserve ‘Fraser’ Archives; own calculations
Examples of “short-lived” inflation spikes such as after WWII and the Korean War were accompanied by significant restraint in broad money. Milton Friedman noted that to contain inflation, the Fed should strive for money supply growth to be around 4% higher than the growth in the “real” economy (i.e. about 4% + 1.7% today). This is broadly consistent with the long-run chart on right.
(3) Interest rates are closer to Taylor-rule levels
When interest rates are below inflation, inflation seems to be less transitory and more persistent (i.e. future readings of inflation correlate highly with previous month’s readings). A recent analysis by Summers, et al highlighted how the inflation challenge today is just as significant as the early 1980s (though obscured because of definitional changes to CPI). Volcker’s 10ppt increase in the FF rate reduced inflation by c. 5ppts (in today’s terms); today’s 3ppt rise in rates does not seem sufficient.
(4) Excess savings are spent down
Excess savings are still very elevated. The “demand shock” is unlikely to dissipate until this has begun to normalize via higher inflation, higher interest rates or dis-savings.
