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Inflation remains tame, but the future remains uncertain

News from the inflation front continues to be quite benign, despite the numerous signs of rising inflation pressures that I have been citing since early last year. This chart shows the headline and core measure of the Personal Consumption Deflator, arguably the most comprehensive measure of inflation at the consumer level, and also the Fed's favored indicator of inflation. Some years ago the Fed established a range of 1-2% for this indicator, and by this measure inflation has been within its target range for the past 18 months. Prior to that, however, inflation was consistently above its target from 2004 through 2008. Over the past 5 years, the PCE deflator has risen at a 2.2 annualized rate, while the PCE core deflator is up at a 2.0% annualized rate; so when viewed from a long-term perspective, the Fed is finally on the verge of getting things right.

Ordinarily I would cheering this news. After all, from a supply-side perspective low and stable inflation is of paramount importance, since it provides a fertile field for confidence in the currency and for the investment that fuels growth and job creation. However I continue to be concerned about the potential for rising inflation, if for no other reason than the fact that monetary policy is in totally uncharted waters given the massive expansion of bank reserves in the past 20 months. Traditional indicators of monetary error such as gold (up 370% in the past 10 years and inches from a new all-time high), the value of the dollar (only 5% above its all-time low in inflation-adjusted terms relative to a large basket of currencies), real interest rates (the real Fed funds rate is negative), and the yield curve (still historically steep), suggest that at the very least the Fed is erring on the side of ease, and they have been very upfront in admitting this.

So while the official inflation numbers are almost as good as one could hope for, one's confidence in the future behavior of inflation cannot be very high. There is a lot of uncertainty surrounding the inflation picture, and that is not good. Thus, I consider monetary policy to be acting like a headwind to the economy, keeping growth from being as robust as it otherwise might be. Fiscal policy is another headwind, sapping the economy's strength by redistributing money from the most productive to the least productive.

Most of the supply-siders I know share these views. Interestingly, they run completely counter to the views expressed by many mainstream economists, who see fiscal and monetary policy as important sources of stimulus. So important, moreover, that they worry terribly that the economy is effectively on life-support and could not survive even the slightest reduction in monetary or fiscal stimulus. If nothing else, it's fascinating how reasonable people can take diametrically opposing views of the facts and come to similar conclusions: namely, that while the economy is recovering, we are unlikely to experience a robust recovery, and there are many reasons to worry. And that's why I think that we are still in a bull market, because true bull markets always have to climb one wall of worry after another. Optimism is in short supply.

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