Saturday, July 14, 2012

Who's afraid of inflation?

Central banks continue to point to fears of inflation as their justification for not doing more to generate growth and fight unemployment. I find their concern about inflation almost impossible to understand and in this post I will explain why.

Inflation: A problem of the past

As this chart shows, inflation has been dormant since the mid-90s. It hasn't been a serious problem for 30 years, since 1982. Inflation is in red, while unemployment is in blue. And unemployment remains far above the 5% level which has sometimes sparked inflation in the past.

Global conditions don't favor inflation

When inflation was last a serious problem, in the 1970s, it wasn't just a US issue. As the next chart shows, it was a global problem. Japan is in red, the UK in green, France in orange and Germany in blue. Japan and the UK had even more serious inflation than the US. Today, global inflation is lower than at any time in the past 50 years.

The bond market isn't worried

The next chart shows the yield on ordinary 10-year Treasuries in green, and on inflation protected bonds in blue. Bond rates are lower than at any time in the past 50 years. Real interest rates are negative. The difference between ordinary and inflation protected bonds gives an implied inflation forecast of 2.5%.

Demand is very weak

The next chart shows housing starts in red, and GDP in blue. In past recoveries, falling interest rates would encourage home building, and that added demand would pull the economy out of recession. The housing market is badly broken, and housing starts remain at very low levels despite very low interest rates. In the past month there have been a few stories indicating an upturn in housing, which is a rare piece of good economic news, but there is a long ways to go to get back to normal levels.

When inflation was a problem, in the 1970s, demand was much stronger, with housing starts running at over 2 million units.  Growth surged to over 5% back then.

Today, growth is extremely weak by comparison with past recoveries. It is below 2.5%, which is unusual for an economy that is not in recession.

Car demand is also unusually weak.

Unemployment in catastrophically bad

Not since the Depression have so many been unemployed for so long, yet Ben Bernanke and the Federal Reserve don't seem to care. The longer people stay unemployed, the more skills they lose.

We have an economy with surplus capital, industrial capacity and labor, and very weak demand. This is not the sort of economy that generates inflation. Yet the Bernanke Fed appears to have given up on its mandate to fight unemployment.

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