Inflation – Donald Marron

Inflation Remains Below Fed Target

The Federal Reserve reportedly wants consumer inflation of about 2 percent per year, as measured by the personal consumption expenditures price index, affectionately known as the PCE. By that standard, Fed policy appears too tight, despite near-zero rates and ongoing QE:

Over the past year, the headline PCE (dashed blue line) has increased only 1.0 percent, and the core PCE (orange line) is up only 1.1 percent. The core PCE strips out often-volatile food and energy prices not, as some wags would have it, because economists don’t drive, eat, or heat their homes, but because the resulting series appears to be a better predictor of future inflation trends (i.e., less noise, more signal).

At the moment, both measures are close together — and far below the Fed’s alleged target.

Is the Trillion-Dollar Platinum Coin Clever or Insane?

Policy wonks are debating whether a trillion-dollar platinum coin would be a clever or insane way for President Obama to play hardball with Republicans in the upcoming debt limit battle. Here’s what you should know about this crazy-sounding idea:

1. A legal loophole gives the Treasury Secretary apparently unlimited authority to mint platinum coins.

Treasury is forbidden from printing money to cover government deficits. Treasury must issue debt, while the Federal Reserve independently controls our nation’s monetary printing press.

That is exactly as it should be. But there is an arcane exception for platinum coins. To serve coin collectors, Treasury can issue platinum coins of any denomination. That creates an intriguing loophole: Treasury could bypass the collector market and mint a trillion-dollar platinum coin. By depositing it at the Federal Reserve, Treasury could keep paying bills after we’ve fully exhausted our borrowing limit.

2. Most observers think this is a terrible idea, but the legal arguments against it are weak at best.

A who’s who of commentators has already objected to the coin on legal, economic, political, and image grounds (see, for example, John Carney, Matt Cooper, Tyler Cowen, Kevin Drum, Jim Hamilton, Heidi Moore, and Felix Salmon). I’m no lawyer, but the legal arguments seem wholly unconvincing. The language of the statute is clear, and in any case, the executive branch gets away with expansive actions in extreme times. During the financial crisis, for example, Treasury aggressively interpreted its authorities in order to bail out GM and Chrysler and to backstop money market funds. If default became a real possibility, the same expansiveness could easily justify a platinum coin.

3. The economic arguments against the coin are stronger but manageable.

There’s a good reason that Treasury is forbidden from printing money to pay our debts: inflation. Many economies have been ruined when profligate governments turned to printing money. But minting the platinum coin needn’t mean monetizing our debt. The Federal Reserve has ample ability to offset any inflationary impact by selling some of the trillions in Treasury securities it already owns. As long as the Fed does its job, inflation would not be a risk.

4. The best arguments against the platinum coin involve image and politics.

Minting a trillion-dollar coin sounds like the plot of a Simpsons episode or an Austin Powers sequel. It lacks dignity. And despite modern cynicism, that means something.

It would also be premature. President Obama and the Republican and Democratic members of Congress have roughly two months to strike a debt limit deal. There is no reason to short-circuit that process, as painful as it may be, with preemptive currency minting as the now-famous #MintTheCoin petition to the White House suggests.

5. Nonetheless the platinum coin strategy might be better than the alternatives if we reach the brink of default.

Analysts have considered a range of other options for avoiding default, including prioritizing payments, asserting the debt limit is unconstitutional, and temporarily selling the gold in Fort Knox. All raise severe practical, legal, and image problems.

In this ugly group, the platinum coin looks relatively shiny. In particular, it would be much less provocative than President Obama asserting the debt limit is unconstitutional. That nuclear option would create a political crisis, while a platinum coin could be a constructive bargaining chip. As Josh Barro notes, President Obama could offer to close the platinum coin loophole as part of a deal to raise or eliminate the debt ceiling.

6. If necessary, Treasury should mint smaller platinum coins, not a trillion-dollar one.

A trillion-dollar coin is eye-catching and ridiculous. That’s why it’s filled the punditry void left by the fiscal cliff. But a single coin makes no policy sense. No federal transactions occur in trillion-dollar increments.

Among the largest transactions are Treasury bond auctions, which today raise about $25 billion at a time. If necessary, Treasury could issue individual $25 billion coins, each in lieu of a needed bond auction. Still ridiculous, to be sure, but less so as it would calibrate coin issuance to immediate financing needs.

Steve Randy Waldman suggests as even more granular approach: issuing coins denominated in millions not billions. Such “small” denominations would be even less ridiculous and could potentially be used in transactions with private firms, not just Fed deposits.

Of course, the best path would be a bipartisan agreement to increase the debt limit, address spending cuts, and strengthen our fiscal future, all settled before the precipice. If we reach the brink, however, minting million- or billion-dollar platinum coins would be better than default.

Chain, Chain, Chain, Chain CPI

Over at the Moment of Truth project (a continuation of the president’s fiscal commission), Adam Rosenberg and Marc Goldwein make a compelling case that the government should use a different inflation measure when calculating cost of living increases and indexing the tax code:

Maintaining purchasing power in spending programs and indexing various parts of the tax code is an important policy goal. However, policymakers should ensure that the most accurate measure of inflation is being used.

To correct the problem of over-indexation, many have proposed switching to the chained CPI [consumer price index] to provide a more accurate measure of inflation for indexed provisions in the federal budget. This switch was recommended by the National Commission on Fiscal Responsibility and Reform (“Fiscal Commission”) and the Bipartisan Policy Center ‘s Debt Reduction Task Force (“Domenici-Rivlin”). It has been incorporated into a large number of other plans, including from the Heritage Foundation on the right and the Center for American Progress on the left. An overwhelming majority of economists from both parties agree that the chained CPI is far more accurate measure of inflation than the CPI measurements currently in use.

In addition to improving technical accuracy, switching to chained CPI would have the secondary benefit of reducing the deficit – by about $300 billion over the next decade alone.

For the reasons they mention, I endorse this change and predict it will be part of any “grand bargain” on America’s budget.

With apologies to Aretha Franklin (and any of you with sensitive music sensibiities), let me suggest a theme song for the effort:

Chain, Chain, Chain, Chain CPI

Chain, chain, chain, chain, chain, chain

Chain, chain, chain, chain CPI

For these long years, we have indexed all wrong

We pay too much, that leads to fiscal pain

And now money’s getting tight

But we have no need to cry

We know what to do, oh a better measure we can try

Chain, chain, chain, chain CPI

P.S. To my readers who believe that the regular CPI understates inflation, rather than overstating it: Yes, Aretha’s song is “Chain of Fools”. And yes, that makes it easy for you to make up lyrics that mock the chain CPI rather than endorse it. Have fun.

How is Housing Affecting Inflation? An Update

A few months ago, I argued that housing was messing up inflation measures, in particular the core CPI. With last week’s release of fresh CPI data, I decided to check in to see if that’s still true.

Answer: Yes, but less so. The cost of housing is still rising slower than for other core goods and services, but the gap has narrowed.

In my earlier post, I found that year-over-year core inflation through October was a remarkably low 0.6% and that housing costs (as measured by the CPI for shelter) had fallen 0.4%. As a result, core inflation less shelter was 1.3% — low, but not remarkably so.

We now have data through January: core inflation has picked up a bit to 0.9% over the past 12 months. Shelter costs rose 0.6% over the same period, and core inflation less shelter is 1.2%.

As you can see, the big change is that shelter costs over the past year are now rising, not falling:

Bottom line: Housing costs have dragged the core CPI down over the past year, but not as much as was true a few months ago.

P.S. My earlier post provides details about the BLS measure of shelter prices.

Is Housing Messing Up Inflation Measures? Yes, But …

Here’s the simplest argument in favor of the Fed’s decision to restart quantitative easing:

The economy remains very weak. Unemployment, for example, is still almost 10%, and the underemployment rate is close to 17%.
Key inflation measures are exceptionally low. The core consumer price index (CPI), for example, is up only 0.6% over the past year.
It’s unlikely that Congress and the White House will do anything to stimulate the economy.

In short, the economy is struggling, inflation appears tame, and the Fed is the only game in (Washington) town.

Items (1) and (3) are, I suspect, not controversial. Moderate economic growth is moving us in the right direction, but has done little to create jobs or reduce the yawning output gap. And given the Republican’s election gains, it’s hard to imagine a new round of fiscal stimulus (except an extension of the expiring tax cuts — a form of anti-anti-stimulus).

Item (2), however, is highly controversial. Some commentators argue, for example, that it’s not appropriate to focus on core measures of inflation, which exclude volatile food and energy prices. Others argue that the government systematically (and, perhaps, intentionally) understates inflation.

I will leave those old debates to the side today and focus on a third, more contemporary question: Is housing messing up inflation measures?

Although the housing bubble popped several years ago, America is still adjusting to its aftermath. Falling house prices don’t directly show up in the CPI, but over time they do result in lower rents and lower estimates of the rental equivalent for owning a home. My question is how big an effect those falling housing prices are having on measured inflation.

To start, note that the core CPI really is running at exceptionally low levels:

Indeed, core inflation is well below the levels that inspired the previous round of deflation worries back in 2003.

Now let’s look at what’s happening with the shelter component of the CPI, which tracks the cost of owning or renting a home:

The CPI for shelter has fallen off a cliff. Shelter price inflation averaged about 3% from 1995 through 2007. Over the past year, however, it’s negative.

Shelter makes up almost a third of overall consumer spending, so you might expect that weak shelter prices are having a big effect on measured inflation. They do:

If you strip out shelter from the core CPI, you find that the remaining consumer prices have risen at a moderate pace over the past year (1.3%) – low, but not exceptionally low. Indeed, the economy came much closer to deflation back in 2003, by this measure, than it has so far today.

In short, the ongoing weakness in housing is a key reason why measured inflation is so low. But — and this is an important but — inflation still appears quite moderate even when you adjust for this effect. At 1.3% over the past year, the core CPI less shelter certainly doesn’t inspire concern about inflationary pressures. And if you look more recently, you find that this measure of inflation has been falling (e.g., the pace of inflation was about 1% annually over the past six months).

Bottom line: Housing weakness has indeed pushed measured inflation down a great deal, but it’s not the only factor at work.

Note 1: BLS tracks four costs of shelter: rent of primary residence (for renters), owners’ equivalent rent of residences (for homeowners), lodging away from home, and tenants and household insurance. Lodging and insurance account for only 3.5% of shelter, so it didn’t seem worth the trouble to strip them out to get a housing-only measure. You will sometimes see analysts do this comparison using the BLS measure of housing costs. Housing is about one-third larger than shelter because it includes household energy and utilities purchases, furnishings, and other household operations. For that reason, I think shelter is a better measure for exploring the relationship between the housing market and measured inflation.

Note 2: According to BLS, food comprises about 14% of consumer expenditures, energy about 9%, and shelter about 32%. So the core CPI less shelter covers about 45% of consumer expenditures. So use it with care.

Merle Hazard Goes to the Parthenon

… in Tennessee, that is. But he’s singing about Greek debt:

Given all the recent discussion about inflation and deflation, let me also recommend Merle’s earlier hit, which includes my favorite lyric: “… will we be Zimbabwe or will we be Japan?” (So far, I think Japan is much more likely.)

Treasury is Issuing More TIPS

As noted by the Wall Street Journal this morning (“U.S., in Nod to Creditors, Is Adding TIPS Issues“), Treasury is issuing more Treasury Inflation-Protected Securities (TIPS). Today’s auction involves $10 billion 10-year notes; one estimate suggest that total TIPS issuance this year will be $80-85 billion. Still small compared to our nation’s overall borrowing needs (somewhere in the $1 trillion range, not including rolling over existing debt), but a real boost to the TIPS world.

As I discussed in two earlier posts (here and here), many observers have recommended that Treasury increase TIPS issuance. The WSJ piece emphasizes one particular set of advocates: our creditors who are beginning to worry about inflation:

TIPS, which account for less than 10% of the $7 trillion Treasury market, offer investors a way to hedge against inflation as their value rises along with the increase in consumer prices. The fixed returns on nominal Treasurys, in contrast, can be eroded over time by inflation, which especially affects long-term bonds.

…

The small size of the market for inflation-protected securities means many large investors who want to be able to sell easily still prefer other ways to hedge against inflation risk, such as commodities.

But in the past year, China and other large foreign investors have become vocal about their concerns that the large U.S. fiscal deficits and the Federal Reserve’s ultra-loose monetary policy will lead to a spike in inflation. That would hurt the value of their large holdings of nominal Treasurys.

U.S. officials reassured China in late July that the Treasury remained committed to its TIPS program and would take investors’ views into account when drawing up its issuance plans. That pledge was seen as a commitment to increasing TIPS sales.

More TIPS to Finance Our Growing Debt?

As you may noticed, the U.S. needs to borrow vast amounts of money. Which raises an interesting question: how should we finance that debt?

The Government Accountability Office (GAO) has taken note of this question and has begun a series of reports on debt management. In its first report, released today, the GAO provides a ringing endorsement of inflation-indexed bonds, aka TIPS (Treasury Inflation Protected Securities). The title of the report pretty much summarizes its conclusions: “Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges.”

The report provides a nice history of the TIPS program, which dates back to 1997, and the challenges it has faced. The number one challenge? Liquidity. Regular Treasury securities are the most liquid in the world and, as a result, investors are willing to pay a premium to own them. U.S. taxpayers thus benefit from the low interest rates our government has to pay on its debt. Unfortunately, TIPS are much less liquid and thus don’t enjoy the same benefit. GAO thus suggests that actions to improve liquidity (e.g., more frequent auctions) could help bring down interest costs.

GAO also recommends that longer-dated TIPS be issued as the U.S. moves to lengthen the maturity of its debt. As noted in the following chart, the current maturity structure of U.S. debt is heavily skewed to short maturities:

More than $3 trillion of U.S. debt will come due by the end of 2010 alone.

The reliance on short-term debt makes sense when near-term interest rates are incredibly low, as they have been lately. But interest rates will rise again one day (perhaps sooner than many anticipate according to a recent op-ed by Fed Governor Kevin Warsh), and the government should therefore be evaluating how it will lengthen maturities. GAO believes that TIPS should be part of that.