MacroScope

Sure, many U.S. inflation indicators have been moving higher in recent months. But that’s because most of them are really a look into the rearview mirror, argue economists at JP Morgan. In a note entitled “The rise in U.S. inflation is yesterday’s headache,” they say the same pattern was observed in early 2008, just before a deepening financial crisis dragged prices lower across the world economy:

At first glance the rise in inflation looks anomalous against the backdrop of persistently disappointing U.S. and global growth and hints at an intractable stagflation problem. But it is very likely that the rise in both inflation and core inflation will prove temporary and soon recede. In this regard,the inflation performance in early 2008 provides a useful model. Then, as now, inflation rose while the economy was weakening. And then, as now, the rise in inflation mainly reflected the upward pressure on goods prices from much higher commodity prices and a weakening dollar.

That means the Fed, which has just announced a fresh effort to push down long-term borrowing costs, may have room to ease monetary policy further if it feels the need.

“Inflation is always and everywhere a monetary phenomenon.” That insight of Milton Friedman’s underpins the general perception of a rising money supply as associated with a booming economy. So why, as Europe teeters and the United States struggles, have U.S. monetary aggregates like M1 and M2 been spiking sharply in the last two months? According to Paul Ashworth, chief economist at Capital Economics, it is a knee-jerk reaction to fear, which has driven investors away from European securities and into dollar-denominated deposits:

The surge in M2 over the past couple of months is very similar to the one seen after the collapse of Lehman Brothers three years ago.  … The shift clearly reflects renewed concerns about the health of banks in light of their exposure to euro-zone sovereign debt. In particular, investors are withdrawing their money from accounts at foreign banks.

Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.

One particularly striking passage in minutes to the Fed’s August meeting signaled such an approach was much closer to becoming policy than investors and economists had believed:

In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting.

Fed Chairman Ben Bernanke’s speech to the Economic Club of Minnesota was long on theory and short on details. Still, Bernanke made one thing clear: the central bank is revving up to ease monetary policy further. Most analysts are looking for some sort of effort to push down long-term rates at the September meeting. While Bernanke did not offer any further guidance on method, he did present a very distinctive sense of direction.

A renewed focus on growth ratcheted the Fed chief’s tone up a notch from his remarks at Jackson Hole:

The Federal Reserve will certainly do all that it can to help restore high rates of growth and employment in a context of price stability.

Let’s face it: inflation is a lagging indicator and Federal Reserve officials look at it that way. So for all the talk that the Fed now faces a higher bar for a third round of quantitative easing, the rise in core consumer prices to 1.8 percent in July is likely to be seen as temporary. As analysts from Commerzbank put it, “the weak economy should help to contain inflationary pressure.”

More worrying for policymakers, particularly the more dovish members of the Federal Open Market Committee, are hints the third quarter may not be showing a lot of the improvements built into official forecasts. A string of reports ranging from consumer sentiment to manufacturing suggest things may have actually taken a turn for the worse in August. From a Goldman Sachs note:

The Philadelphia Fed index unexpectedly fell to -30.7 in August. In the past, this level for the index has only been observed in or immediately prior to recessions (though the index was around -20 in 1995 for a brief period, and the economy did not fall into recession).

Price stability remains the only needle in the compass for the European Central Bank, even when it is buying government bonds, the 17-country bloc’s central bank strived to argue on Sunday.

ECB President Jean-Claude Trichet said, in the statement announcing extension of its bond-buying programme, that the decision was made to keep inflation at an acceptable level.

“This programme has been designed to help restoring a better transmission of our monetary policy decisions – taking account of dysfunctional market segments – and therefore to ensure price stability in the euro area,” Trichet said.

When calibrating monetary policy, central bank officials often turn to the Taylor rule, a useful construct for thinking about the relationship between unemployment and inflation pioneered by John Taylor, former Treasury official and Stanford economics professor. So as the U.S. economy appears to falter and investors begin to speculate on the prospect of another round of monetary stimulus from the Federal Reserve, it’s worth checking in with Taylor’s model.

Economists at Goldman Sachs sought to do just that in a recent research note, and they found something interesting: if one accounts for the effects of unconventional easing through bond purchases as estimated by Fed Chairman Ben Bernanke, then policy is currently as accommodative as it needs to be.

To call for additional easing, these Taylor rules would need 1. much smaller estimates of the effectiveness of asset purchases than cited by Bernanke and/or 2. significant further deterioration in the Fed’s economic outlook.

What more does India’s central bank have to do? Last week data showed March inflation rising to almost 9 percent on an annual basis. More importantly, core inflation is above 7 percent for the first time in 3 years meaning demand-side pressures are rising fast. And that’s despite the Reserve Bank of India raising interest rates eight times since last March.

The inflation data comes just after a quarterly HSBC report based on purchasing managers indexes showed that inflation in India seemed impervious to monetary policy tightening.

The truth, is the inflation-fighting central bank has little backup from the government which remains stubbornly in spending mode. Its foot-dragging on reform and foreign investment contributes towards keeping food price inflation high. This year’s fiscal deficit target is 4.8 percent of GDP and even this
is seen as optimistic.

Ben Broadbent’s appointment to the Monetary Policy Committee ought to dispel any notions that the Bank of England would be left short of hawks after the departure of Andrew Sentance.

A brief look at the history of Reuters polls shows that Goldman Sachs’ UK economists – led by Broadbent – were uber-hawkish in their outlook for British interest rates early last year.

In January 2010, Goldman predicted rates would rise to 1.5 percent by end of the second quarter of last year, and 2.5 percent going into 2011 — hugely out of step with both the consensus and as it turned out, reality. Rates went nowhere last year, and are still at a record low of 0.5 percent.

CEOs are, of course, ebullient by nature.

So it's no surprise that confidence about growth prospects is bouncing back as emerging markets continue to barrel along and even sluggish developed economies show signs of recovery.

What is, perhaps, remarkable is just how far confidence has returned. The latest survey of 1,201 company bosses by PricewaterhouseCoopers shows it is back almost to pre-crisis levels.

But how much should we trust the bouncing boardroom Tiggers? There are also plenty of Eeyores in Davos, warning about fiscal deficits, growing economic imbalances and the rising threat from inflation.