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The New and Improved Producer Price Index
For the financial markets, Fed Chair Yellen’s monetary policy testimony was largely about appearances. She did not rock the boat, pledging continuity in monetary policy. She was cool, confident, and in charge. However, her written comments contained only one brief mention of the inflation outlook. While some people are still worried that inflation will “take off” at some point due to the Fed’s accommodative policies, others are worried that the low trend in inflation could continue.
When Ben Bernanke became a Fed governor in 2002, he led the Fed’s fight against the possibility of deflation (a fall in the overall price level). The Fed feared deflation more than anything else. Deflation would reduce incentives to spend and invest, leading to even weaker growth and more deflation – “a death spiral.” However, by the end of his tenure as Fed chairman, Bernanke was a lot more complacent. What changed? Japan’s experience with deflation – moderate price declines, but no deflationary spiral – and the anchoring of long-term inflation expectations reduced the Fed’s fear. Expectations of inflation have remained remarkably steady in recent years, largely because the Federal Reserve had fought hard to achieve credibility. That’s not going to change under Yellen’s leadership.
Still, there are a number of concerns that a continued low trend in inflation could hurt the economy. For one, real interest rates are what matter. Lower inflation implies higher real rates and slower economic growth (than would have occurred otherwise). Some prices rise or fall more than others. A low inflation trend means that we’d likely see outright deflation in some industries, which could create a number of problems for business fixed investment. Borrowers naturally get some debt relief over time through inflation (this should be factored in for lenders as well as borrowers). A lower trend in inflation means less debt relief through inflation. Finally, a low trend in inflation could be signaling broader economic weakness.
Inflation is always a monetary phenomenon, but we observe it through pressure in resource markets. On Wednesday, the Bureau of Labor Statistics will expand the Producer Price Index to include services (in fact, 63% of the new headline figure will be services). The BLS has already released these data on an experimental basis, so we have some idea of what it looks like.
Up to now, the PPI report has been comprised of three separate gauges: finished goods (consumer goods, capital equipment), intermediate goods, and crude materials. The idea was to be able to observe inflation pressures marching through the pipeline. However, much of the growth in the economy over the last few decades has been in services. The new report will contain more detail on inflation in trade, transportation, warehousing, and other business services. Prices related to intermediate demand will be divided into four stages. It will be some time before economists and financial market participants develop a full appreciation of the details in the report. However, it seems unlikely that pipeline inflation pressures are going to be much of an issue in 2014.
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