Inflation Jitters

We noted earlier the discussion from Greg Ip:

The Fed pays more attention to core inflation, which is less volatile because it excludes food and energy. But that picture is also troubling. Since April 2004, core inflation measured by the Fed’s preferred price index has been at or above the top of policy makers’ preferred 1.5% to 2% for all but five months, notes Doug Elmendorf, a former Fed economist who is now a scholar at the Brookings Institution. It dipped in the spring of last year before edging higher by year end. The Fed, by allowing inflation to consistently run higher than its preferred range, risks feeding higher expectations of inflation in the public, which will make it harder to get inflation back down, Mr. Elmendorf noted. Mr. Bernanke, whose term is up for renewal in 2010, certainly wants to avoid a recession. But he would probably prefer a mild recession now to a high risk of increased inflation and a deeper recession later.

While Greg was noting a possible short-run trade-off between inflation and unemployment, Jim Jubak fears stagflation:

Stagflation is coming. Lock up your portfolio. We could be on our way to a replay of the 1970s … In the United States, headline inflation started off the decade at 5.5% in 1970, peaked at 12.2% in 1974 and again at 13.3% in 1979, and didn’t drop below 4% until 1982. For the ’70s as a whole, inflation averaged 7.4% annually. In comparison, inflation in the 1960s averaged 2.5% annually.

Let me explain why I don’t have inflation hysteria by providing a graph of the difference between the nominal rate on 5-year Federal bonds versus the real interest rate as given for the 5-year Treasury Inflation Indexed Notes. The difference, which is often taken as the market’s expectation of inflation, has floated around an average of only 2.17 percent since January 2004. Our graph also shows a general tendency for both nominal and real interest rates to have risen during the 2004 to 2006 period when the economy was getting closer to full employment. As the labor market showed signs of weakness during 2007, the Federal Reserve did allow the nominal rate to decline, which also led to lower real interest rates. Whether this easier money can allow us to avoid a recession is a difficult question. But for those who are hysterical over renewed inflation, might I suggest you relax and actually look at the real world data. Jubak’s claim that we are about to see the inflation ratios of the 1970’s is a real stretch.