Inflation & The New Abnormal

The trend in headline inflation slowed last month, the Labor Department reports. Consumer prices rose 2.9% for the year through January—a slightly slower pace than the annual 3.0% rise as of December. Meanwhile, core inflation—consumer prices less food and energy—inched higher on an annual basis, advancing 2.3% for the year through last month, or up slightly from December’s 2.2% rate. What does it all mean? For the moment, nothing much has changed relative to the previous update. But because we’re still in the new abnormal, higher inflation remains a positive. By that standard, today’s CPI offers a mixed bag of news on the margin.

As a quick bit of background, the new abnormal is a world where higher inflation is greeted enthusiastically by the markets. In the wake of the 2008 financial/economic crisis, higher inflation expectations (defined as the yield spread between nominal Treasuries less their inflation-indexed counterparts) have been accompanied by higher stock prices, and vice versa. That’s abnormal in the grand scheme of U.S. macro history, but it’s been the rule in recent years. It’s debatable if the new abnormal has run its course, as I discussed earlier this week. No one rings a bell when these big-picture regimes start or end, and so definitive answers are available only well after the fact.
Meantime, until the economy has transitioned to a robust and sustainable state of growth, and the crowd recognizes the transition as durable, it’s best to assume that the new abnormal rolls on. That means that we should be wary of a persistent round of disinflation. As the market monetarists advise (Scott Sumner and David Beckworth, for instance), the policy prescription of the highest order these days is raising nominal GDP as a tool for juicing the real economy (i.e., real or inflation-adjusted GDP). Explaining this goal in its crude and somewhat misleading form equates with raising, or at least maintaining inflation at a certain level.

With that in mind, we can see in the chart above that the pace of headline inflation has been slowing. “We’ve seen the peak” in inflation, says Jeremy Lawson, a senior U.S. economist at BNP Paribas. “There is still a reasonable amount of slack in the labor market.”
If inflation’s pace continues to slow, and if the new abnormal persists, the combination may spell trouble for the economy in the months ahead. One clue that suggests we can’t ignore this risk, however marginal, is a slower rate of nominal GDP’s growth (real GDP plus inflation) in 2011’s fourth quarter: 3.7% on an annualized basis, down from 3.9% in Q3. Yes, the more widely watched real GDP growth rate accelerated to 2.8% in Q4 from 1.8% previously. But the market monetarists tell us that if nominal GDP continues to slow, the trend may take a toll on real GDP in the current climate. As such, lower inflation isn’t helpful. One day that will change, but not yet.

Fortunately, recent economic reports suggest that the economy is likely to keep growing, as yesterday’s update on initial jobless claims implies, for instance. Meanwhile, core inflation remains in an uptrend, which suggests that falling inflation isn’t a danger (i.e., core inflation has a history of providing a more reliable benchmark for measuring pricing trends). Maybe nominal GDP isn’t destined to fall after all.
The notion that higher inflation is helpful (still) at this stage confuses some pundits. But recall that falling inflation since 2008 has been accompanied by a deteriorating economic outlook. Fast forward to the present and recent history shows that higher inflation has gone hand in hand with a rising stock market and a revival in the economy’s growth prospects. Counterintuitive? Perhaps, but that’s par for the course in the new abnormal.
Update: Marcus Nunes notes that the 1.3% one-year-ahead inflation outlook via the Cleveland Fed is roughly equivalent to its 10-year-ahead counterpart. In addition, Nunes provides us with a chart that shows that inflation expectations overall are the lowest since 2009: