The Waning Threat of Deflation versus Two Easy-Money Pieces

I swear I had to read the latest James C Cooper piece in BusinessWeek twice just to be sure what I was reading. So I thought about doing a comparison to various academics and their current surveys of economic conditions, one was Paul Krugman's latest piece. This would provide a look to see where consensus was and where it was not, so I could gauge which argument(s) I found to have a more solid foundation.

James, an alumnus from NC State where he received his bachelors and masters degree, shows that Personal Consumption Expenditures declined from a year ago by 0.5% or 0.0005. He attributes most of this to the drop in gasoline prices. Here is the table from the BEA release.

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As you can read from the chart his argument is correct. The index declined 23.7% in the energy good/services subcategory in the same time period.

However, now we can contrast this with Mr. Krugman's, with a BA from Yale in Economics followed by a PHD in Economics from MIT, evidence. He looks at the similar indicator formed from the Consumer Price Index. It also has a total value and one excluding energy and food prices because of their noted volatility. However, in this version instead of removing food and energy totally, he chooses to trim the data, that is remove the most volatile price movements to get to a "core" price movement. Here is the chart.

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Here we can see the quarterly data from the 1st and 2nd quarter plus the data from September. So you can see the total annualized CPI for the three periods, in order, are: 1.5%, 3.3% and 2.0%. However, if you trim out the volatile prices, depending on the amount trimmed you usually what is basically a horizontal asymptote and those are: 2.3%, 1.0% and 0.5%, a clear downward trend. In fact if you look at James's chart it shows the same information, that both core and the more volatile are in a downward trend. So we have to separate pieces of data that suggest inflation will not be a concern moving forward.



The title of the chart even states in full caps CORE INFLATION WILL CONTINUE TO DRIFT LOWER. So rationally you could think that Mr Cooper and Mr Krugman are on the same page. "This suggests that disinflation is proceeding rapidly. And a falling inflation rate, possibly even deflation, means that a zero interest rate is less expansionary than it seems."

James, however, entitles his piece The Waning Threat of Deflation?!?!

It seems to me and anyone looking at these charts that are provided as evidence that deflation is on its way.

James bases his assertion on a few observations: inventories may have been cut too deeply along with capital spending (investment) and payrolls. He argues that inventory restocking, the actual fall of capital stock which affects the denominator in capacity utilization therefore utilization rates could increase faster in a recovery, and the fact that 6% productivity is unsustainable, thus new employees will need to be added. I would argue that the latter is the most important in James's arsenal as Consumption provides 70% of GDP, however a person cannot be a consumer without a job.

Luckily, just this morning I was reading a post by James Hamilton, a PHD and Masters in Economics from UC-Berkley, about unemployment and inflation. He found that by running a model of two year average of inflation and inflation expectation he could arrive at a very high correlation. Here is his chart.
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His chart shows that inflation is still falling off a cliff and until unemployment turns, not just the stemming of jobless claims but actual growth of jobs that inflation will continue to fall. From his words, "but the forecast of the model for the average inflation rate between 2009:Q4 and 2011:Q4 is -0.5%." Again reiterating that without jobs no growth of GDP is sustainable, thus no inflation.

Finally, there is my new favorite graph. Median Duration of Unemployment. That is to say unemployment is not a bad thing per se, there is a natural creative destruction as employees from a dying industry like paper sales move to a more dynamic industry like alternative energy or health care. Unemployment is bad however when the economy cannot quickly move applicable skill sets, like sales of paper to sales of solar panels. Both require knowledge of a product and industry so they should be quick substitutes but when the economy is not doing this task people stay unemployed for long bouts of time. This, of course, impinges on growth. Let us see what the current outlook looks like.



Highest ever since it has been tracked.

The Fed has to act as training wheels for the US economy. It must support and guide the economy into growth but even as growth resumes it must not remove it stimulus too soon or relapse will occur. I do not believe Bernanke will remove stimulus until unemployment falls below 7%.

So in conclusion, I am not certain what James's article is about at all. He states that inflation will allow the Fed leeway to raise rates but does not specify how inflation will be brought about except for plausible stories without an econometric model to show how inflation will be transmitted. Merely stating that an inventory build or utilization rate climbing by decreasing the stock of capital does not guarantee sustainable growth based on an organic recovery. One of the major lessons for Bernanke as a student of the Depression was that the removal of stimulus in 1936 and 1937 caused the economy to crash in 1938. Then again James was the chief economist of the American Forest and Paper Association.

Unemployment

Just a few charts to discern what happens to employment during a recession. Really more of a vocabulary post.



So this is the the percentage of the adult civilian population (> than 16 years old) that could be employed. It is divided into three subsections: employed, unemployed and not in the labor force. The not in labor force are generally retirees and students. Now the percentages look different than what you may hear described on tv or in print. This is because they are again percentages of the total employable universe. The unemployment rate measures only the unemployed versus the labor force. This is shown below.



So here you can see the 9.4% unemployment figure that economist describe.

So the largest category is Civilians over the age of 16 and it is right now approximately 235.9 million people. It is made up of the labor force and the aptly titled Not in Labor force, which stand at 154.5 and 81.4 million people respectively. 9.4% of the labor force is unemployed currently and that represents 14.5 million people.

I wanted to look at the chart again. There are some interesting nuances going on in the data. One is that the not in labor force number is growing both in percentage terms and nominal terms as the population has increased. This most likely stems from the baby boomer generation entering their retirement years. This is why the employment as a percentage of adults has fallen below 60%.This is the first time it has been this low since 1984.