Fed-worrying

Three weeks I wrote that:

Right now, I wouldn’t be at all surprised if a year that began with a deflation/growth scare ended with an inflation scare.

Now, predicting the “return of inflation” is something of a trope of post-2009 economic commentary and one that was (barring a brief 2011/12 commodity price driven spike) been incorrect.

Still, there’s plenty of reason to think — and to use the most dangerous words known to economics — that this time might be different. At least in the US and UK.

Commodity prices are bouncing hard from what looks like a hugely overdone collapse. Labour markets (whilst far from being tight) are looking tighter. The Philips curve may well be flatter than in the past, but it’s still there and whilst there is almost certainly hidden slack (in the form of the fall in participation in the US and involuntary part time work and self employment in the UK) headline unemployment rates are now lower and even the hidden slack is starting to be eroded.

Meanwhile core inflation has been creeping higher.

According to Gavyn Davies, Fulcrum’s models are now pointing to US inflation rising faster than currently forecast by the Fed.

Fed Vice Chair Stanley Fischer’s comment yesterday that he can see the “first stirrings” of inflation had caused something of, well, a stir.

Yes, wage growth remains weak by historical standards but so does productivity growth. And weak productivity growth means that even relatively weak wage growth can feed through into rising unit labour costs and ultimately rising inflation.

This potential pick up inflation has got some very smart people worried. Take Conor Sen who wrote yesterday that:

It’s finally happened. I’m starting to look for signs of economic overheating, overly aggressive monetary policy tightening, and eventually, recession…
Over the next several months as energy and currency-related headwinds subside and the US hits full employment the Fed will begin to snuff out this expansion, which is what they see their job being. Economic growth in 2016 should be pretty good, and there’s a good chance 2017 will be as well. But by 2018? There’s a reasonable chance that by then, if the economy doesn’t fall into recession on its own the Fed will put us there.

I don’t really know where the US economy or any other one will be 2018 but I am sure that a lot will depend on the actions of the Fed over the coming 18 months or so.

And for what it’s worth — I’ve got a lot of trust in Yellen and Fischer.

It does strike me that when headline wage growth is sub-3% and when even measures like the one from the Atlanta Fed below are showing relatively (in the long run) weak wage growth, it’s a bit early to worry about overheating.

The big question is — what does the Fed’s reaction function look like faced with rising inflation?

The unspoken assumption of many is that faced with a rise in inflation we’ll see a pre-2008 style hiking cycle.

There’s a strange symmetry to much Fed-worrying at the moment. For everyone eager to shout “policy mistake” about December’s hike, there’s someone else willing to shout “policy mistake” that the hiking cycle didn’t start earlier.

We’ve moved from a pre-2008 world in which central banks where generally trusted to get on with their jobs and hit their inflation targets to a world where there’s much less faith, where a great many prominent economists are fretting about deflation risks and fair few are worrying about the Fed getting behind the curve and a large rise in inflation.

I think we are moving out of a deflation scare into an inflation scare. But the emphasis in both cases is on the word scare.

The sentence of my own that I quoted at the beginning of this post (right now, I wouldn’t be at all surprised if a year that began with a deflation/growth scare ended with an inflation scare) was followed by this one:

The Fed would do well to look through both.

I find myself in the position of thinking that the Fed has so far played this about right and hoping that they continue to do — gradually tightening policy as inflation rises and being as happy to look through a temporary period of above target inflation as they were a below target one.