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Inflation is tame, no need for more QE




The CPI was unchanged in July, has actually fallen at a -0.8% annualized rate over the past three months, and is up at an annualized rate of only 1.1% in the past six months. However, virtually all the weakness in the headline CPI comes from declining energy prices. As the chart above shows, the Core CPI is up at a 2.2% annualized pace over the past six months. 




As the charts above show, energy prices are on the rise again, so the weakness in the headline CPI we have seen has already run its course. Gasoline prices at the pump are up over 10% in the past month, and crude oil prices are up almost 20%. It's best, therefore, to just look at the core CPI as the better measure of inflation for now.


The current rate of increase in core inflation is only slightly less than the increase in overall CPI inflation has been, on average, over the past 15 years. While it's certainly good that inflation is not higher, the best that can be said is that it has been averaging just above the Fed's target for quite some time. As the first chart in this post shows, the Fed was moved to engage in quantitative easing only when the core CPI threatened to enter deflationary territory. That is not the case today, and given the ongoing strength in industrial production and the ongoing increase in jobs, the Fed would have a very hard time justifying more QE at this time. The economy is struggling, but that's not a reason for more monetary stimulus.


In fact, as this next chart suggests, the Fed has been very accommodative for a long time, and may be overstaying its welcome in accommodative territory. This chart compares the level of capacity utilization, a proxy for the economy's idle capacity, to the real Fed funds rate, the best measure of how easy or tight monetary policy actually is. When capacity utilization rises, signaling declining idle capacity and increasing supply constraints, the Fed almost always tightens policy. When capacity utilization declines, the Fed almost always eases policy. Today the gap between the relatively high level of capacity utilization and the very low level of the real Fed funds rate is rather big and growing. The risk of the Fed remaining "too easy for too long" is rising. The market is sensing this, and it shows up in forward-looking inflation expectations, particularly in the 5-yr, 5-yr forward breakeven inflation embedded in TIPS and Treasury prices: over the past 11 months, this measure of inflation expectations (the Fed's favorite, in fact) is up from 2.0% to 2.7%.

Despite the relative tranquility of consumer price inflation, there is little if anything in the inflation and economic data that would justify further quantitative easing. Increasingly, it's looking like the Fed's next move will be a tightening, not another easing.

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