Yesterday saw a relatively quiet trading day in US equities with the Dow Jones Industrial Average falling by 19 points to 10948. I would imagine that minds were already turning towards todays non-farm payroll and unemployment numbers. For those who do not follow these matters non-farm payrolls and in particular the components of it are used as measures of the level of and indeed changes in US employment. Hence the numbers are used as a guide to the state of the US economy. In our current position where the recovery has so far earned itself the title of the “jobless recovery” one can see how the figures achieve some importance. I do however have a note of caution, as it is a shame that numbers which are often heavily revised are going to bear a weight of expectations that their accuracy and reliability simply does not justify. We could head off this afternoon on an expectations joyride today that if it were say corrected by a revision next month might be too late as the next FOMC meeting is on November 2nd and 3rd.
One place where there was more of an equity movement was Japan where the Nikkei 225 index fell by 95 points to 9588. This widened the spread between it and the Dow Jones to 1360 points indicating yet more underperformance by the Nikkei. This was in spite of the Japanese cabinet endorsing a new fiscal stimulus plan of some 5.1 trillion Yen which translates to 62 billion US dollars. Although this plan has yet to go through Parliament many may be wondering about Prime Minister Kan’s promise to make the fiscal deficit his first priority. Moving onto the Yen exchange rate at 82.42 versus the US dollar we have now been below the level of Japan’s initial intervention on the fifteenth of September for more than 24 hours. The rate against the stronger Euro has performed more weakly and is at 114.87.
Fears of More Monetary Easing or QE2 feed inflation fears
As the debate has progressed on whether the US Federal Reserve and other central banks including the Bank of England should undertake further monetary stimulus measures I would like us just to draw breath for a moment. In a somewhat febrile atmosphere I feel that many have forgotten that the Federal Reserve has its pedal quite close to the metal as it is with interest rates very near zero and the policy of QE-lite aimed at maintaining the size of its balance sheet at around 1.3 trillion dollars. So any further measures would be in addition to this and I have noticed recently that estimates of the size of QE2 are rising with some reaching around 6 trillion dollars. Also other types of stimulus are being mooted such as targeting a new higher inflation level or an even more expansionary policy which would target an absolute price level.
A likely effect of this is higher inflation expectations
If you think about all these proposed stimulus measures it may not be a surprise that there are starting to be increased fears of inflation in the United States. We do have one way of measuring this as there are what are called TIPS or Treasury Inflation Proofed Securities in the US. So if we take the 30 year version of TIPS and compare it with the conventional 30 year Treasury Bond we get an estimate of inflation over the next 30 years as that should be the difference between the too. This is currently 2.23% and has risen since late August from just under 1.9%, and this ties in virtually exactly with the rise in speculation over QE2. We can do the same for the ten-year maturities and we find that the estimated inflation rate has risen from 1.51% to 1.93%.
Now I counsel caution in using these numbers as an exact guide as I do not think that investors behaviour stands up to that in terms of accuracy but I think the trend which is clear and does coincide with a change in expectations on QE2 can be used as a guide. If anything one might expect these comparisons to under record what is happening as without getting too technical TIPS are not pure inflation instruments they do have a nominal element.
Somewhat surprisingly I see that Richard Fisher President of the Dallas Fed agrees with me as according to the Financial Times he said.
If the Fed is successful with QE, inflation breakevens should be higher
I could almost set a quiz question here,before this passage of time when did you ever here a central banker outside Japan say something like that?
Are there other possible signs of inflation?
I have reported often on the increases in commodity prices that have been evident this summer. The Commodity Research Bureau spot index dipped a little this week but has now recovered to 487.48 which represents a rise of 30% over the past year. Much of this has come from food prices but metals have been strong too.
Added to this has been a recent recovery in the price of crude oil. If we take West Texas Intermediate crude front month futures price as our measure then the price of a barrel of oil has risen from US $ 71.53 at the end of August to US $81 now for an increase of 13%. So there are upwards influences on the price level. For those who read the economics section of the BBC website these numbers may come as something of a surprise so please feel free to check them for yourselves which ironically in general terms you can for oil prices anyway on the same website. As I like to be even-handed I would like to point out that over the past two weeks the BBC has aired an excellent documentary on the Iraq war.
In some ways this is a return to the inflation/deflation debate however I wish to make a some more subtle points as the debate is far from simple and anyway it should be an inflation/disinflation debate. Also readers might like to take a look at my article of the 2nd of July which challenged US measurement of inflation.
1. If the US economy is slowing down but continuing to grow then extra stimulus measures could easily lead to higher inflation. I do not know the employment numbers as I type this but up to now the economic statistics do not justify QE2.
2. Whilst the media and many economists seem to obsess on double-dip fears,what about a continuation of slow growth followed by QE2? That sounds like a recipe for stagflation to me. This may well be convenient for many sovereign nations who have high and increasing levels of nominal debts. If wage rises stay at low rates this may not be quite so convenient for individual debtors but they too may have some gain.
3. As estimates and projections for QE2 seem only to be rising one cannot avoid the thought that inflation at higher levels than that implied by stagflation could be triggered. This of course could coincide in a horrible policy mix.
So my thought is that economists should raise their noses from the grindstone of double-dip fears and consider other possible implications of what s happening. Indeed let me return to a theme of mine expressed in a question. As the existence of QE2 would clearly imply that QE1 failed, on what grounds can one reasonably expect QE2 to succeed?
The UK experience with inflation
This has been problematic to say the least. The UK Monetary Policy Committee does not have the leeway the Federal Reserve has to talk of raising inflation levels as our inflation is well above target. Indeed our previous measure of inflation RPI-X at 4.7% exceeds its previous target of 2.5% by some 2.2%. I would remind you that this has led a member of the Shadow Monetary Policy Committee to say this as I reported on the 5th October.
the Bank’s inflation target has no credibility to lose.
And with him being in favour of more monetary stimulus measures we got an estimate of the potential inflation which might result from it.
There will be a modest inflationary price to pay on exit – perhaps annual CPI inflation will reach 6% and RPI inflation might reach 10%. But that is a problem for 2012 or 2013.
The last sentence is a rather literal version of “kicking the can down the road” to my mind. Why worry about the future?
Shop Prices and Producer Prices tell us a different story from the consensus
This week has given us some evidence on this front. The British Retail Consortium produced some estimates for the behaviour of shop prices in September.
Overall shop price inflation increased marginally in September to 1.9% from 1.7% in August, taking it to the highest rate for five months. Food inflation increased to 4.0% in September from 3.8% in August.
These are not entirely unfamiliar trends and yet again make me wonder about the Bank of England’s definition of the word temporary. Just to add to this we have received producer price numbers for the UK this morning and according to the Office for National Statistics we got the following.
Output price ‘factory gate’ annual inflation for all manufactured products rose 4.4 per cent in September.
Input price annual inflation rose 9.5 per cent in September compared to a rise of 8.7 per cent in August
As ever there is a mixture of information here but after noting that output inflation fell back from 4.7% there are again troubling developments here. The rate of increase in input prices is rising again after a dip making the dip look temporary rather than the other way round, and over time one would expect this to feed into output prices. Also there has been a lot of debate over the impact of indirect taxes on inflation so let me present the number for output price inflation excluding them 4.5%. Interestingly this now exceeds the headline rate.
For those interested in a breakdown of why input prices are rising we hear a familiar message.
Prices of imported materials as a whole (including crude oil) rose 0.9 per cent between August and September
I understand that I am pursuing a theme today which in many areas of economics is out of fashion. If you are a student of Phillips curve and output gap theory these trends I have discussed today should not be happening.However the actual evidence from our economy leaves one with a choice do you believe reality as best we can measure it or do you cling to a theory that not only is not explaining events today but has performed disappointingly since the credit crunch began?
With a slight touch of irony as many of those who cling to such theories are Keynesians I shall leave you today with a quote from the man himself.
When the facts change, I change my mind. What do you do, sir?