Fed’s Yellen on Inflation

Fed vice-chair Janet Yellen is probably, after Ben Bernanke, the most influential voice on the Fed, and what she says provides clues to what the Fed will be doing in the near and intermediate term future. Today she spoke to the Economic Club of New York.

While the speech (which can be found here) is worth reading in its entirety, it is too long for me to do a full presentation and paragraph by paragraph response. Thus I will pull out some of the key paragraphs and respond to those. I generally agree with what she is saying.

“Some observers have attributed the recent boom in commodity prices to the highly accommodative stance of U.S. monetary policy, including the marked expansion of the Federal Reserve’s balance sheet and the maintenance of the target federal funds rate at exceptionally low levels. Such an interpretation of recent developments naturally leads to the conclusion that the Federal Open Market Committee (FOMC) should move promptly toward firmer monetary conditions. Indeed, some have even raised the specter of a return to the high inflation of the 1970s in arguing for the urgency of monetary policy tightening.

“Increases in energy and food prices are, without doubt, creating significant hardships for many people, both here in the United States and abroad. However, the implications of these increases for how the Federal Reserve should respond in terms of monetary policy must be considered very carefully.

“In my remarks today, I will make the case that recent developments in commodity prices can be explained largely by rising global demand and disruptions to global supply rather than by Federal Reserve policy. Moreover, empirical analysis suggests that these developments, at least thus far, are unlikely to have persistent effects on consumer inflation or to derail the recovery.”

I do not think it would be a good idea to tighten up on monetary policy when unemployment is still running at 8.8% — and that is understated due to a decline in the participation rate. This is particularly true since fiscal policy is in the process of becoming concretionary. Commodity prices are influenced by world supply and demand, not just by U.S. supply and demand.

“In particular, a rapid pace of expansion of the emerging market economies (EMEs), which played a major role in driving up commodity prices from 2002 to 2008, appears to be the key factor driving the more recent run-up as well. Although real activity in the EMEs slowed appreciably immediately following the financial crisis, those economies resumed expanding briskly by the middle of 2009 after global financial conditions began improving, with China — which has accounted for roughly half of global growth in oil consumption over the past decade — again leading the way.

“By contrast, demand for commodities by the United States and other developed economies has grown very slowly; for example, in 2010 overall U.S. consumption of crude oil was lower in than in 1999 even though U.S. real gross domestic output (GDP) has risen more than 20 percent since then. On the supply side, heightened concerns about oil production in the Middle East and North Africa have recently put significant upward pressure on oil prices, while droughts in China and Russia and other weather-related supply disruptions have contributed to the jump in global food prices.”

I would note that the decline in U.S. oil consumption is probably a bit overstated, since we now import a lot of embedded energy. For example, it takes a lot of energy to make steel. When that steel was made in Pittsburgh or Gary Indiana, that was counted as U.S. energy consumption. If we import the steel from China, it counts as Chinese energy consumption, even though the steel was used here in the U.S.

Still, the point about increased emerging market demand, particularly in China and India, is the primary reason for higher commodity prices. Poor harvests in many parts of the world have also played a key role as far as agricultural commodity prices are concerned.

“First, it does not seem reasonable to attribute much of the rise in commodity prices to movements in the foreign exchange value of the dollar. Since early last summer, the dollar has depreciated about 10 percent against other major currencies, and of that change, my sense is that only a limited portion should be attributed to the Federal Reserve’s initiation of a second round of securities purchases.

“By comparison, as I noted earlier, crude oil prices have risen more than 70 percent over the same period, and nonfuel commodity prices are up roughly 40 percent. Put another way, commodity prices have risen markedly in all major currencies, not just in terms of U.S. dollars, suggesting that the evolution of the foreign exchange value of the dollar can explain only a small fraction of those increases.”

One can quibble if 1/7th of the rise in oil prices is a small fraction of the increase or not. It is certainly less than half, but is still significant. Since we tend to be net exporters of food commodities, it is unlikely that the fall in the dollar has had anywhere as big an effect as the implied 25% of the rise for non-fuel commodities.

Then again, there are many commodities that are non-agricultural and non-fuel. The weakness of the dollar may be playing a bigger role in the increase in, say, copper prices than it is in wheat prices. Still, the dollar weakness — which I would argue is good for the economy at this time (it will tend to raise exports, cut imports and thus reduce the drag of net exports on the economy) — is at most a partial explanation of rising commodity prices.

“A second potential concern is that U.S. monetary policy is boosting commodity prices by reducing the cost of holding inventories or by fomenting ‘carry trades’ and other forms of speculative behavior. But here, too, the evidence is not compelling. Price increases have been prevalent across a wide range of commodities, even those that are associated with little or no trading in futures markets.

“Moreover, if speculative transactions were the primary cause of rising commodity prices, we would expect to see mounting inventories of commodities as speculators hoarded such commodities, whereas in fact stocks of crude oil and agricultural products have generally been falling since last summer.”

Not all inventories are well-tracked, but if there were a surge in hoarding, it would show up in the more visible inventories, such as in the commodity exchange numbers. While there may well be significant “hidden inventories” out there, it is unlikely that they have surged while the more visible inventories have dwindled.

Whenever commodity prices go up, there is a natural urge to blame it on speculators, but for every futures contract bought, one must also be sold. In the absence of rising inventory levels of the physical commodities, I don’t think the “speculators are guilty” meme has it right. They are certainly not the primary cause of the rise, and probably just a minor contributor.

“No single measure of underlying inflation is perfect, but it is notable that these measures have exhibited a remarkably consistent pattern since the onset of the recession: All show the underlying inflation rate declining markedly to a level somewhat below the rate of 2 percent or a bit less that FOMC participants consider to be consistent with the Fed’s dual mandate.

“For example, core PCE price inflation stood at less than 1 percent over the 12 months ending in February, down from 2-1/2 percent over the year prior to the recession. Trimmed-mean measures of inflation have also trended down over the past couple of years and are now close to 1 percent.

“I want to emphasize that this focus on core and other inflation measures that may exclude recent increases in the cost of gasoline and other household essentials is not intended to downplay the importance of these items in the cost of living or to lower the bar on the definition of price stability. The Federal Reserve aims to stabilize inflation across the entire basket of goods and services that households purchase, including energy and food.

“Rather, we pay attention to core inflation and similar measures because, in light of the volatility of food and energy prices, core inflation has been a better forecaster of overall inflation in the medium term than overall inflation itself has been over the past 25 years.“

I would note that if the Fed were following headline inflation, they would have been jacking up rates fast in the spring and summer of 2008. That would have made the financial crisis much, much worse. Core inflation and the inflation of items that tend to be “sticky” are the things a central bank needs to be looking at when managing monetary policy. Core inflation is very well behaved, and this suggests that the recent surge in headline inflation is likely to be short-lived. To really get inflation going, you need a wage-price spiral. With 8.8% unemployment, that just is not going to happen on the wage side.

“Nonetheless, a sharp rebound in economic activity — like those that often follow deep recessions — does not appear to be in the offing. One key factor restraining the pace of recovery is the construction sector, which continues to be hampered by a considerable overhang of vacant homes and commercial properties and remains in the doldrums. In addition, spending by state and local governments seems likely to remain limited by tight budget conditions.

“Moreover, while the labor market has recently shown some signs of life, job opportunities are still relatively scarce. The unemployment rate is down from its peak, but at 8.8 percent, it still remains quite elevated. And even the decline that we’ve seen to date partly reflects a drop in labor force participation, because people are counted as unemployed only if they are actively looking for work.

“Some observers have argued that the high unemployment rate primarily reflects structural factors such as a longer duration of unemployment benefits and difficulties in matching available workers with vacant jobs rather than a deficiency of aggregate demand. In my view, however, the preponderance of available evidence and research suggests that these alternative structural explanations cannot account for the bulk of the rise in the unemployment rate during the recession.

“For example, if mismatches were of central importance, we would not expect to see high rates of unemployment across the vast majority of occupations and industries. Instead, I see weak demand for labor as the predominant explanation of why the rate of unemployment remains elevated and rates of resource utilization more generally are still well below normal levels.”

We are far from out of the woods as far as unemployment is concerned, although we do seem to be on the right track. There are big headwinds the economy still faces. In addition to the State and Local Government budget cuts she cites, I would add the recent budget cuts at the Federal level.

I fully agree that the bulk of the high level of unemployment is cyclical, not structural. If it were structural, we would be seeing some areas of the country and sectors of the economy where lots of jobs are going begging and wages are soaring. I can’t think of a sector of the economy where that is the case, and geographically the only place that really fits that description is North Dakota.

There is much more in the speech, and it is worth reading. However the reader’s Digest version is this. Core inflation is well contained, and that supply and demand globally are the key reason for higher commodity prices, not Fed policy.

Raising rates now, or reversing course and selling off the accumulated assets of the Fed (quantitative tightening) would not do much to bring down inflation, but it would bring down economic growth. The Fed is unlikely to raise the Fed Funds rate before the end of this year and the QEII program will probably be completed as scheduled in June.

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