Is Inflation About to Come Back?
Could 2014 be the year that the U.S. economy gets back to normal, with faster inflation as one consequence? At least, that's the argument that Business Insider's Joe Weisenthal made over the weekend. Such predictions have been wrong before, but enough has changed during the past six years to make this a serious position.
The difference between this recovery and previous ones is that people no longer were willing, or able, to borrow as they once did. The effect was a steady contraction in the amount of debt owed by the household sector -- until now. The latest Flow of Funds data show that American households increased their total borrowing for the first time since 2008. In theory, this could be attributed solely to the hedge funds and private-equity firms included in that category, but it's more likely that the combination of rising asset values, an improving job market and relatively robust real wage growth has made regular people more confident about the future.
Why should a growing economy cause inflation to accelerate? Milton Friedman famously quipped that "inflation is everywhere and always a monetary phenomenon," but this isn't actually very useful for people who want to know why the prices of goods and services rise. After all, nobody knows just what exactly a "monetary phenomenon" is. Over the past six years, the Fed's balance sheet has more than quadrupled. That sounds like a lot, but M2, which is the total value of checking and savings accounts, has only increased by about 50 percent. Broader measures of money have been little changed since 2008.
In a fascinating post for the CFA Institute, Matt Busigin argued that the capital stock and labor supply were much better predictors of future inflation than anything having to do with monetary policy. Domestic capital investment has been weak for years, in part because capacity was developed abroad. Even now, businesses are reluctant to invest in additional productive output when there are so few customers.
At the same time, we are now in a situation where, despite high unemployment, there may not be much spare capacity left in the labor market. That may sound strange (or even offensive) given the yawning "employment gap" found by researchers at the International Monetary Fund, but it's possible. Suppose, for a moment, that most of the long-term unemployed and those who temporarily dropped out of the labor force never work again. This would be a tragic waste of millions of people's talents and a damning failure of public policy, but it is plausible given what we know about employers' tendency to discriminate against the jobless. Now consider that the number of people out of work for six months or less has fallen to levels associated with a booming economy.
If companies are only willing to hire people who are employed, they may soon have to compete with each other for workers. That means bidding up wages. The good news is that those with jobs may be about to enjoy years of real income gains as bargaining power shifts from capital to labor. The corollary is relatively faster consumer price inflation and lower corporate profit margins -- unless the Fed decides to lean against the incipient economic recovery.
I'm not persuaded that U.S. inflation is about to accelerate, and neither are the markets. Household deleveraging may have merely paused rather than ended. Companies may prefer to hire the millions of workers sitting on the sidelines rather than pay their existing employees more. The global capacity glut may keep prices suppressed for far longer than was true in the past. Commodity prices could remain quiescent or continue to fall, which would be good for real incomes but do little to the official price indexes. Even so, the time may soon come when a bet on inflation's return will stop sounding so nutty.
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