The Baffling Mystery of Inflation Deflation

The core consumer price index eked out a year-over-year increase of just 1.7% in June, the slowest in two years. Stripping out shelter costs, core inflation grew just 0.6%, the most sluggish rate since 2004. Personal-consumption expenditures are growing at a 1.4% pace, shy of the Federal Reserve’s 2% target.

Stable inflation lets businesses hike prices of the goods and services they sell, and raise wages. It’s no coincidence the labor market is tight and unemployment is down to 4.4%, but wages are growing at a glacial pace of about 2.5%.For a stock market braving new peaks—the Standard & Poor’s 500 index just snagged its 27th record high of 2017—weak inflation reinforces concerns that the Fed is tightening even when our slow-growth, low-interest-rate economy is going nowhere fast.

Why does inflation keep falling short of expectations? For one thing, excess debt encourages saving, not spending with global debt hitting an all-time high this year of $217 trillion, roughly 327% of global gross domestic product. Next, aging populations also tend to save more and spend less, and even though demographic trends here are sprightly compared with, say, Japan and Europe, over the past decade the annual growth in the U.S. working population has shrunk from 1.3% to just 0.5%.

On top of that, automation, robots, and artificial intelligence are pressuring human wage expectations. Technology disruption may one day prompt policy changes that could include, for example, taxing robots or levying higher taxes on Silicon Valley profits. For now, corporations continue to emphasize cost-cutting over risk-taking, and wide swaths of the labor market see that their ability to maintain wages and incomes are under enormous threat from technology.

The worrisome thing is how inflation seems to have befuddled central bankers. Fed chair Janet Yellen has said that weak recent inflation readings are merely “transitory,” and she pointed to a price war in mobile phone services and a decline in prescription drug prices as momentary inflation depressants. But the Fed has brushed aside feeble inflation as transient year after year after year, and still inflation has yet to catch up to the Fed’s 2% goal. Back in 2015, for example, Yellen said inflation was held back by collapsing oil prices and weakening imports in the face of our strong dollar. Well, energy prices have since rebounded from early-2016 depths, and the dollar just declined to a 30-month low against the euro. But there’s always something else, and new culprits springing forth to hold inflation hostage.

IN THE COMING MONTHS, expect the Fed to be extra sensitive to any whiff of faltering growth. With inflation already below target, the Fed has less cover to continue its painstakingly telegraphed plan to raise rates and shrink its balance sheet. At first, this will cheer a market accustomed to the addictive fix of easy money. But the Fed has fewer tools at its disposal if growth starts to flag, what with interest rates already low. On the other hand, if inflation were to start climbing, financial markets—which are pricing in only a 39% chance of one more rate hike through year end—just might be startled.

Kopin Tan, Barron’s, July 22, 2017

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