The minutes from the Fed's April meeting show it remains open to expanding its quantitative easing operations (debt monetization!), forecasts moderate growth in 2010, and they see an undershoot of their inflation objectives even on a two-year horizon.
Fed officials cut their growth forecast (central tendency) and raised their projection for the unemployment rate. Nonetheless, they see less risk of deflation in 2010 than I do.
While global economic growth in the first half of 2009 is still up in the air, there is no doubt that the costs of the deepest global recession since WWII will linger for a number of years.
One consequence of the severe decline in global GDP in the United States is the large rise in unemployment rates and the accompanying plunge in manufacturing capacity utilization.
I think it could be helpful for the investor to have some insight into how the slack caused by the plunge in global and U.S. manufacturing utilization will affect the underlying pricing complex in the coming quarters. At present, core CPI inflation in the developed economies is expected to fall to 0.5 percent year-over-year by the fourth quarter 2010.
Take care, this forecast has a lot of downside risk.
Milton Friedman said: "There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output." So, keeping that in mind, we'lll have to see how inflation responds to the disinflationary impulse from extremely low levels of resource utilization along with how the response to inflation expectations will determine the inflation outlook for the next several years.
These dynamics center around movements along the Phillips curve, which shows the inverse relation between the rate of unemployment and the rate of inflation in an economy, versus shifts in the Phillips curve since it shifts up or down when inflationary expectations rise or fall, as argued by Edmund Phelps and Milton Friedman.
Based on the assumption of a stable Phillips curve since 1990, the plunge in resource utilization in the current downturn will yield a much larger 4 percent-point fall in core CPI inflation in the developed economies than the 1 percent-point fall currently projected. The United States will not decouple from the rest of the developed world.
Historical data point to downside risk to the inflation outlook, but upside risks also are present. Should central banks move too slowly to unwind the unprecedented policy stimulus even as economic slack is removed, the end result could be a sharp escalation in inflation.
Indeed, with central bank balance sheets having been scaled up considerably, a faster-than-projected rise in the money multiplier could translate into a surge in credit that boosts growth well beyond expectations. This eventually would prove inflationary, especially if it was accompanied by a rise in inflation expectations.
That said, I consider it highly unlikely there is an immediate inflation problem, i.e., in 2010. History has taught us that inflation expectations tend to move in the same direction as core inflation, not in the opposite direction. Thus, a significant slide in core inflation in 2010 is likely to challenge inflation expectations to the downside, notwithstanding the extraordinary support that policymakers are providing to the economy and markets.
Even if it turns out to be the case that the current policy stance is unwarranted, i.e., if a global boom lies just around the corner, the magnitude of the output gaps across the developed economies will give central bankers ample time to adjust.
So, investors shouldn't get carried away by all that inflation talk now. Time will come to worry about inflation, but we aren't there yet.
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