When should we start worrying about inflation?

Jan Hatzius is now forecasting that inflation will soon exceed the Fed’s 2% target for the PCE:

Goldman’s Jan Hatzius wrote Sunday that unemployment should continue to decline to 3% by early 2020, noting the labor market also has room to accommodate more wage growth. Hatzius predicted that average hourly earnings would likely grow in the 3.25% to 3.50% range over the next year.

That rapid pace of wage growth could set the Fed up for a “meaningful overshoot” of its 2% inflation target.

“If unemployment is (perhaps well) below 3.50% and inflation above 2%, we think Fed officials will need to be quite confident that growth will stay at or below trend to sound an all-clear on further rate increases, which could translate into a large easing in financial conditions and a return to growth rates well above trend,” Hatzius wrote.

Hatzius wrote that the economy needs to slow to avoid overheating, and worries that inflation could run away if the Fed does not take action. For now, Goldman has a baseline forecast of 2.3% for core PCE — which it noted as within the Fed’s comfort zone — but warned that inflation is poised to move higher on President Donald Trump’s tariffs.

The note also warned that with the labor market continuing to tighten, inflation will likely push “notably, not just slightly, higher.”

Hatzius said a slowdown could stabilize the unemployment rate, and already predicts that the economy will calm to a GDP growth rate of 2.6% in the fourth quarter. But if the slowdown is not enough, unemployment could destabilize into 2020 and inflation could run rampant.

If Hatzius is correct (and I greatly respect his judgment), then Fed policy is currently too expansionary.  The Philadelphia Fed consensus forecast is for 2.1% PCE inflation in 2019 and 2020.  (I’ll be very interested in the next forecast, which should be out soon.)  On the other hand, TIPS spreads continue to show sub-2% inflation over the next 5 years (once adjusted for the CPI bias) but they are subject to bias from a modest risk spread.

So what would tell me that we have an inflation problem?  Lots of news articles saying “It’s not that bad, because if you take out the rise in the price of X, inflation is only running at Y”.  I saw literally dozens of such articles in the 1960s and 1970s, and essentially 100% of them were incorrect.

It is true to inflation indices can be distorted by the actions of individual markets, but only if it reduces aggregate supply.  In that case, you’d see rising inflation, falling RGDP growth and modest NGDP growth.  In fact, both NGDP and RGDP growth have recently been quite strong, so don’t believe any articles about it not being so bad because it’s concentrated in health care, or education, or rents, or tariffs, or kiwi fruit prices, or some other special factor.  Special factors are not an excuse when NGDP growth is at a pace that is unsustainable if we hope to keep inflation close to 2%.

I’m not a forecaster, so I’m still pretty agnostic on this.  My baseline forecast is still for a slowdown in NGDP growth (predicted by the Hypermind market) and no recession or high inflation in the near term.  That’s good.  But I’ll be watching very closely for signs of excess.  The most likely policy mistake being made right now is too easy, not too tight.

PS.  Hypermind is currently forecasting 12-month 5.2% NGDP growth.  That represents a forecast of a slowdown to 4.2% over the next two quarters, from the 6.2% (actual) rate over the past two quarters.



16 Responses to “When should we start worrying about inflation?”

  1. Gravatar of Michael Michael
    6. November 2018 at 11:46

    I thought we wanted to overshoot 2% (and stop using that as a target in favor of NGDP) in order to get back to the price levels we would be seeing if 2008 and the subsequent non-recovery had not happened.
    Did that somehow become a bad idea when we got a new president?

  2. Gravatar of Brian Donohue Brian Donohue
    6. November 2018 at 12:10

    Assuming the greater danger right now is that monetary policy is too expansionary, do you have any thoughts on the relative merits of increasing the FFR vs. reducing the size of the Fed balance sheet (quantitative tightening) as a means of checking this? I note that the Fed has recently been doing both.

  3. Gravatar of ssumner ssumner
    6. November 2018 at 14:29

    Brian, Not really, except in general I prefer a smaller balance sheet, so I’d reverse the QE first if given the choice.

  4. Gravatar of Brian Donohue Brian Donohue
    6. November 2018 at 14:34

    It seems to me the Fed may be able to tighten while avoiding an inverted yield curve by judiciously pursuing these two paths simultaneously, which is what they have been doing this year.

    Personally, I just don’t see short-term rates moving much higher in our new normal, low inflation world, so I would emphasize quantitative tightening at this point.

  5. Gravatar of Marcus Nunes Marcus Nunes
    6. November 2018 at 14:55

    It appears banks “cluster” around the forecasting table!
    For a less “conventional” view:

  6. Gravatar of Benjamin Cole Benjamin Cole
    6. November 2018 at 16:07

    Inflation, schmaflation.

    This post asks the wrong question.

    Besides that, I wonder about Hatzuis’ observation that a 3.5% wage increase average would be inflationary. We are seeing productivity gains in the 1% to 2% range.

    More importantly, unit labor costs rising at below a 2% rate.

    There are some worrisome signs in West Coast real estate and retail sales, both appear weak. NYC also.

    I realize the macroeconomics profession is obsessed with 1970s inflation. Well, when the topics are not Argentina, Zimbabwe or the Weimar Republic.

    But usually nations pass through moderate inflation while maintaining economic growth.

    And if we want to raise bogeyman stories, there is always the 20-year deflationary recession that was Japan.

  7. Gravatar of bill bill
    6. November 2018 at 19:54

    A market prediction of 4.2% rate seems like it is very close to the target (or what the target would/should be if they targeted NGDP, not PCE). So not too loose, not too tight.
    But how do we read that in conjunction with this?:

    Does this mean that the NGDP market indicates that NGDP stays on target provided that the Fed does the increases predicted by this market?

    Off topic, isn’t it weird that the interest rate market here puts a 0% chance on any rate cuts over the next 18 months? Maybe I’m reading that wrong?

  8. Gravatar of Benjamin Cole Benjamin Cole
    6. November 2018 at 22:18

    OT, but related to inflation.

    I don’t know where to stick this observation by Moody’s Investor’s Service, so I will stick here in hopes someone will enlighten me a bit.

    “Chinese government easing measures indicate credit relaxation but do not imply a return to automatic bond bailouts. Since June 2018, China’s government has launched several measures to ease financial and monetary conditions, including injecting liquidity into onshore credit market and encouraging financial institutions to provide financing for
    fundamentally sound private-owned enterprises (POEs) and public infrastructure projects. The moves highlight the government’s efforts to balance policy objectives, including derisking the financial system and maintaining economic growth. However, we think the Chinese authorities will still tolerate isolated bond defaults and are unlikely to revert to their former practice of “automatic bailout” of distressed bonds.”


    The PBOC “automatically” bailed out bonds in the not-so-distant past? I have read that the PBOC at one point had bought about $1 trillion in bad loans from the banking system. That kept the banking system liquid and solvent.

    Given China’s stellar growth record of the past 40 years…and that the PBOC is now below a modest inflation target…what does this PBOC bailout system mean?

    It has not led to inflation. It has been consistent with robust economic growth. And it is not a topic of discussion.

  9. Gravatar of Benjamin Cole Benjamin Cole
    6. November 2018 at 22:33

    “Off topic, isn’t it weird that the interest rate market here puts a 0% chance on any rate cuts over the next 18 months? Maybe I’m reading that wrong?”—bill

    Verily, the market reads the Fed right.

    Central bankers get rosy cheeks when discussing higher interest rates and tighter money. It will take a recession—two quarters of negative growth—to get the Fed merely to back off. By then it may be too late.

    Spooky thought; The value of global real estate is about $280 trillion.


    David Beckworth says about 75% on the globe’s central banks key on the Fed.

    So, higher interest rates could trigger property value declines (this happening in West Coast-NYC already?).

    But banks are heavily exposed to property….meaning banks start to tumble. Once banks stop lending on real estate, then property values crater. New property transactions depend on liquid capital.

    Real estate seems at the center of every serious financial-economic collapse in Western economies.

  10. Gravatar of Pete Bias Pete Bias
    7. November 2018 at 04:47

    Just a caution, the A-F rule suggests that money is currently too tight, not too loose. Actual money growth rate being below the rule’s target money growth rate is consistent with the market forecast for ngdp growth rates to fall. If ngdp growth is targeted at 5% the Fed should not be increasing interest rates.

  11. Gravatar of ssumner ssumner
    7. November 2018 at 06:54

    Bill, Yes, these inflation forecasts are conditional on further interest rate increases. Which makes it kind of weird when people cite them as a reason not to raise interest rates!

    Pete, I’d be really worried if the Fed were aiming for 5% inflation.

  12. Gravatar of ssumner ssumner
    7. November 2018 at 06:58

    Michael, No, that became a bad idea about 4 years ago, when unemployment fell to low levels.

  13. Gravatar of ssumner ssumner
    7. November 2018 at 07:12

    Pete, I should clarify that 5% NGDP growth is likely to eventually drive inflation above 2%, causing the Fed to suddenly tighten, causing a recession.

  14. Gravatar of P Burgos P Burgos
    9. November 2018 at 04:50

    What is the A-F rule?

  15. Gravatar of Justin Justin
    9. November 2018 at 12:14

    The Hypermind market is currently not particularly interesting due to it’s short horizon. Quarterly GDP growth is pretty noisy, so you’d expect some regression-to-the-mean after the monster quarters we just had. The interesting questions are: what is year-ahead, two-year ahead NGDP expectations? Are we set up for 5% NGDP or 4%? I of course do my best to distill that from markets at ngdp-adviers.com but there’s no substitute for the real deal. I have tried contacting hypermind about setting up a new contract, was thinking to start a GoFundMe campaign, but they’ve not returned my message.

  16. Gravatar of P Burgos P Burgos
    9. November 2018 at 13:13

    Assuming 1% labor force growth a year and 1% productivity growth a year, wouldn’t an NGDP growth rate of 5% give you about 3% inflation per year? That doesn’t seem too far off from 2% inflation a year. Granted, negative shocks to the economy would lower productivity and labor force growth and push up inflation, but those are the situations in which the Fed already has to choose between employment and inflation.

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