Don’t fear inflation boogeyman: BofA’s Harris

February 13, 2013

Worries about potential side-effects of unconventional monetary policy on financial markets are at least exaggerated, if not a near figment of the imagination.

This appears to be the conclusion of a comprehensively-argued research note by Bank of America Merrill Lynch global economist Ethan Harris.

The risk investors need to focus on is disinflation, not inflation; yet, remarkably, over the last several years critics of the Federal Reserve’s quantitative easing have “hijacked” the inflation debate, Harris says.

Every time the Fed announces a new QE program or inflation ticks up a bit, critics warn of a potential surge of inflation. Sure enough, the QE3 announcement in September caused a knee-jerk jump in inflation breakevens, warnings of surging commodity prices and eventual broad-based inflation. All of this has the Fed on the defensive: their directive talks about what they will do if inflation is too high, but is mute on what they will do if inflation is too low.

Despite dire inflation warnings, Harris says the risk of unwanted disinflation is greater than that of unwanted inflation, reason enough “to fade the bond market sell-off.” Treasury yields surged in January after a last-minute agreement to avoid the “fiscal cliff” encouraged risk taking and reduced demand for safe-haven U.S. bonds, pushing yields higher.

Broad-based inflation measures are falling

After bumping up in 2011, almost every broad-based measure of inflation is falling, says Harris. These include measures of core inflation on a three-, six-, 12- and 24-month basis. The only indicator not dropping increasingly below the Fed’s 2 percent target is the median CPI, which has held steady at just above 2 percent for the last two years, Harris says.

Harris emphasized that the Fed’s favorite gauge of underlying inflation, the core PCE deflator, has risen at only a 0.7 percent annual rate over the last six months.

Even if much of the drop is temporary, headline inflation has been even weaker.

In the last three months the headline CPI, PCE deflator and PPI have all been in negative territory. Over the last 12 months, all are rising at about 1.5 percent.

All this shows the inflationary “bark” of QE3 is much worse than its bite, Harris says. The downward slope of nearly all inflation measures is not a fluke because the sources of disinflation are evident, he says. Almost all of the underlying determinants of inflation – spare capacity, labor costs, imported inflation and inflation expectations – point to weakness. The capacity utilization rate at 78.8 percent remains well below its historical average.

Even if the inflation neutral unemployment rate is  6.3 percent, a conservative estimate, that leaves an unemployment gap of 1.6 percentage points, the largest gap since the early 1980s, Harris says.

With unemployment high, labor costs are “weak and likely to weaken further,” he says.

All three measures of inflation – average hourly earnings, the employment cost index and employee compensation – have been bouncing around in the 1.5 to 2.5 percent range since the 2008-09 recession. Unit labor costs picked up in the fourth quarter of 2012 as output growth plunged, but excluding that distorted number, they have been essentially flat for the last year.

Imported inflation pressures are fading. Commodity prices have been essentially flat over the last year and a half, and inflation expectations remain, in the words of the Federal Open Market Committee, “well-anchored.”

Monetarist frameworks also suggest little risk of near-term inflation, Harris said.

In a monetarist model, easy monetary policy causes acceleration in bank lending and nominal GDP growth. Despite the explosion of bank reserves, both bank lending and nominal GDP growth remain subdued.

“Indeed, the feeble 3.8 percent growth of the last three years is the second weakest period in the last 60 years,” Harris said. Milton Friedman pointed to lags of a year or two from easy monetary policy to inflation, but aggressive QE has been going on for several years, Harris pointed out.

Rent is the one area where inflation is alive and well.

Recall that rent and ‘owners’ equivalent rent’ (OER) together make up almost a third of the PCE (personal consumption expenditure) deflator. Coming out of the recession, demand for rental units rose faster than supply as owners defaulted on mortgages and moved into the rental market. OER inflation rose from -0.5 percent in 2009 to about 2.0 percent in 2011. In the past year and a half, OER inflation has stabilized, perhaps reflecting a better balance in the market as investors buy up homes and rent them out. However, with vacancy rates still low, pressure may return.

The bottom line is that inflation hasn’t bottomed, Harris concludes. His baseline forecast assumes inflation will bounce around the Fed’s 2 percent target, with no clear trend over the next two years. “However, if recent trends continue, we will have to revisit that forecast,” he said.

If this current downdraft sticks, it has important implications for the long-awaited bond sell-off. Lower inflation should not only put downward pressure on breakevens, it will encourage the Fed to stick to its QE program longer. If outright deflation threatens, the Fed could even ramp up its program.

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