Central banks have a poor record on timing stimulus to prevent runaway inflation. Typically, by the time they move to raise interest rates to cool an overheating economy, it’s too late to head big inflation off at the pass.
As you wade through today's raging academic and political debates about the true threat of inflation, what conclusions can you draw as an investor? From our perspective, these profound disagreements among analysts and policymakers only reinforce our view that the US Federal Reserve won't be effective at timing its stimulus and containing runaway inflation.
That means you should act now and consider the inflation-fighting hedges we've been recommending in this ezine and in its parent publication Inflation Survival Letter, before inflation starts eating away at your wealth.
Recent testimony by Janet Yellen, the new head of the Federal Reserve, has only raised concerns by economists and investors that this central bank administrator may do no better that her predecessors. As in the past, the problem is that so-called leading economic indicators are not always timely enough to spot changes—sometimes central bankers even react to the wrong indicators.
The latter concern has arisen in the wake of the Fed chair's congressional testimony on Feb. 11, raising questions about the accuracy of the present unemployment figure of 6.5 percent in describing what’s truly happening in the workforce. This compounds long held concerns that the Fed is flying blind in this economy and its tools to measure the economy are proving inadequate.
To support its twin mandate of price stability and maximum employment, the Fed must know precisely the state of inflation and unemployment to direct effective monetary policy. But many have long argued that the central bank is focusing on the wrong indicators and the Fed chair’s recent comments have only reinforced this pessi! mism.
The core Consumer Price Index (CPI), the Fed’s preferred measure of inflation, is considered by many to be insufficient at the task of gauging inflation because it strips out fuel and food prices. We agree with this assessment. In fact, there’s a concern that by the time core CPI exceeds the Fed’s 2 percent threshold, real inflation will be several orders of magnitude higher.
The Fed would be too late to act if it focused on this indicator alone. In December, core CPI stood at a tepid 1.16 percent, a low reading that is inconsistent with US households’ real-world cost of living increases.
Similarly, to ascertain the unemployment level, the Fed has long relied on the headline number produced by the US Bureau of Labor and Statistics, but this indicator has also come under increased scrutiny.
Economists seem to be at odds as to why unemployment has been plummeting over the past few years as workers have exited the labor force, while at the same time inflation remains persistently low. This contradiction has given rise to the notion that there's greater slack in the labor market than the drop in the unemployment rate suggests (see Chart A).
Chart A: Labor Force Participation Rate & Unemployment Rate
Source: US Bureau of Labor Statistics
The share of Americans who have jobs coming out of the recession has barely budged, but the unemployment rate has changed dramatically.
The participation rate has been falling for more than a decade, which further clouds the issue. Is this trend the result of baby boomers retiring or workers getting discouraged? Yellen must figure it out. Many market observers believe Yellen has focused on this discussion in her testimony in an effort to expand the measures the Fed us! es to giv! e forward guidance.
In her recent congressional testimony, Yellen focused on the U-6 unemployment rate, which counts not only people without work seeking full-time employment (the more familiar U-3 rate), but also counts marginally attached workers and those working part-time for economic reasons, which is significantly higher at almost 13 percent than the unemployment rate that is usually reported. She has also focused on how unemployment rates are vastly different according to demographic categories, such as age, race, gender and location, in many cases as a result of a skills gap.
These issues illustrate a fierce debate over what exactly is happening in the US labor force. Some economists heatedly disagree with Yellen that the reason for the accelerated decline in unemployment is due to discouraged workers that have dropped out.
These economists believe the workforce has permanently shrunk. Those discouraged workers may remain labor force dropouts if the recovery takes too long, but longer-term demographic changes, such as the aging of baby boomers, is skewing the unemployment numbers.
The two viewpoints call for opposite policy responses: If you believe the jobless rate is falling due to discouraged workers, you would likely be inclined to keep stimulating the economy in hopes of bringing them back. If you believe that the decline in the jobless rate is due to demographics or other irreversible factors, there’s no point in stimulating the economy.
The Federal Reserve’s next big monetary policy shift will depend greatly on which indicators—unemployment or inflation—best reflect the condition of the labor market.
Shoot First, Ask Questions Later
Goldman Sachs (NYSE: GS) economists Sven Jari Stehn and Jan Hatzius propose the Fed should focus on wage growth as a primary input into the “reaction function” that dictates its response to changing economic conditions.
They raise the question: Why focus more on wage growth ins! tead of i! nflation, or even the unemployment rate itself? Ultimately, wages will respond to tightening labor market conditions, whereas consumer price inflation may not, they argue. “Low inflation should be indicative of the size of the employment gap,” wrote Stehn and Hatzius in a research report.
“This approach, however, relies on a tight link between slack and price inflation. And the experience of the last couple of years suggests that price inflation is not very responsive to the employment gap at low levels of inflation and seems to fluctuate quite randomly when we are in the neighborhood of price stability. The behavior of core PCE [Personal Consumption Expenditure] inflation between 2011 and 2013 is a good example: core inflation rose by a full percentage point during 2011 and then dropped by the same amount in 2013, without any compelling macroeconomic explanation,” the Goldman economists stated (see Chart B).
Chart B: Price versus Wage Inflation
Source: Dept. of Commerce, Dept. of Labor, Goldman Sachs Global Investment Research
But at least one economics commentator, Michael Ashton, finds fault with this approach because it would penalize wage earners.
The obvious conclusion, Ashton argues, given the absolute failure of the “employment gap” to forecast core price inflation over the last five years, is that the employment gap and price inflation are not particularly related.
“Under the Goldman rule, if wages were rising smartly but price inflation was subdued, then the Fed should tighten," Ashton argues. "But why tighten just because real wages are increasing at a solid pace? That is, after all, one of society’s goals! If the real wage increase came about because of an increase in productivity, or because of a decrease in labor supply, t! hen it do! es not call for a tightening of monetary policy. In such cases, it is eminently reasonable that laborers take home a larger share of the real gains from manufacture and trade.”
On the other hand, if low nominal wage growth was coupled with high price inflation, the Goldman rule would call for an easing of monetary policy, even though that would tend to increase price inflation while doing nothing for wages.
“In short, the Goldman rule should probably be called the Marie Antoinette rule. It will tend to beat down wage earners,” he argues, adding the employment gap has not demonstrated any useful predictive ability regarding inflation. "Moreover, monetary policy has demonstrated almost no ability to make any impact on the unemployment rate."
The upshot: No one in politics or academia seems to know for sure how to contain inflation before it becomes a problem. To protect your portfolio, you must be proactive and follow our time-proven advice.
No comments:
Post a Comment