Ed Dolan's Econ Blog

CPI Inflation Stuck at Zero as Fiscal and Monetary Policy Threaten to Turn Procyclical

According to the textbook prescription, the ideal time to cut government spending and tighten monetary policy is when the economy begins to approach full employment and the first signs of excessive inflation appear. Economists call that kind of preemptive policy countercyclical  because it helps to keep an impending boom from running out of control. On the other hand, premature tightening when a recovery is still incomplete is procyclical. A procyclical policy makes slumps deeper, recoveries slower, and booms hotter than they would be if the economy were left to its own devices.

This week’s news from Washington suggests a turn from countercyclical to procyclical in macroeconomic policy. Today’s  inflation report from the Bureau of Labor Statistics only adds to that impression. As the following chart shows, the headline inflation rate, as measured by the change in the consumer price index for all urban consumers, remained at zero in January for the second month in a row. If we include a 0.2 percent monthly decrease in November, which cancelled out a 0.2 percent increase in October, inflation has been flat for four months now.

To be sure, the headline inflation rate is not the whole story. The all-items CPI remained unchanged in January, in part, because of a drop in energy prices and an end to a ten-month string of increase in food prices. If we strip out volatile food and energy prices, the resulting core CPI increased by 0.3 percent in January. If continued for a full year, that would come out to a 3.7 percent annual rate. However, there is little indication that market participants are interpreting the uptick in core inflation as more than a blip. The Cleveland Fed’s estimate of ten-year inflation expectations, at 1.5 percent, remains very close to its lowest level in the past two decades.

Meanwhile, all signs point to a pending tightening of fiscal and monetary policy.

As far as fiscal policy is concerned, all eyes are focused on the package of across-the-board spending cuts known as the sequester, which will come into effect on March first if nothing is done. Yes, another midnight deal might modify the sequester, but fiscal policy will be tightened in any event,  for the simple reason that both parties want it to be. The only difference between them is that the Republicans want tightening via spending cuts alone, while the Democrats would like the throw some tax increases into the mix.

Over at the Fed, the indications of a change in monetary policy are more subtle. Don’t expect a dramatic boost to interest rates any time soon. Still, the pendulum does seem to be swinging away from the strongly accommodative quantitative easing of the past few years.

Inflation, as measured by the CPI, is not the worry. According to the minutes of their January meeting, released this week, most members of the policy-setting Federal Open Market Committee expect inflation to run at or below the Fed’s target of 2 percent for the foreseeable future. Only a few members see any upside risk to prices in the medium or even the long term. However, several participants in the January meeting expressed concern that the Fed’s huge portfolio of securities could expose it to a risk of large capital losses in case of a future reversal of policy. A few others expressed concerns that the Fed’s program of large-scale asset purchases could lead to the disruption of financial markets.

What lies behind least some of these concerns is a fear of asset bubbles. Asset bubbles are sharp increases in the prices of securities, real estate, or global commodities that can occur even when consumer price inflation remains low. Usually, they pose the greatest risk when the economy is running at or above its level of potential GDP, as during the bubble in the 1990s and the housing bubble in the early 2000s. Today, at least as measured by the Congressional Budget Office, the U.S. economy is still well below potential GDP, but not everyone trusts those estimates. The FOMC minutes tell us that some members noted “uncertainties concerning both the level of, and the source of shifts in, potential output.” It is worth noting that the concern over asset bubbles is shared by some private observers, including Nouriel Roubini.

The recently-released FOMC minutes summarize the concerns of its members in this key sentence:

A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.

In the Fed’s closely guarded language, “a number of participants” is more than “several” or “a few.” Market participants took that to indicate that the Fed’s determination to stick with aggressive accommodation until labor market conditions improve is weakening. In monetary policy these days, when actual changes in interest rates are unthinkable, subtle signals about what the Fed is likely to do in the future take on added importance. Monetary economists like Michael Woodford consider such “forward guidance” to be the main channel through which the Fed can affect the economy when interest rates are at or near zero, as they are now.

The bottom line: All of this week’s news put together—flat inflation, the looming sequester, and the increasing caution of forward guidance from the Fed—point to a distinct procyclical turn in macroeconomic policy. That may or may not mean an actual return to recession, but even if not, gains in output and employment are likely to come even more slowly this year than last.

11 Responses to “CPI Inflation Stuck at Zero as Fiscal and Monetary Policy Threaten to Turn Procyclical”

ThomasGrennesFebruary 23rd, 2013 at 9:49 am

Recent developments in U.S. fiscal policy are a continuation of the change to a procyclical fiscal policy by the U.S. in the last decade or so that has been documented by Jeffrey Frankel. (
Instead of moderating business cycles, recent fiscal policy has had the perverse effect of
magnifying cycles. Making business cycles more extreme is one component of a general
deterioration in the quality of fiscal policy that is being increasingly recognized. Congress going on recess less than two weeks before sequestration is another example of fiscal inadequacy.

kakatoaFebruary 23rd, 2013 at 3:25 pm

Ed, __Thanks for the link to the report! My comment is likely going to take 2 posts- sorry about that. __I noticed that the report is changing a bit: "Average residential prices for utility (piped) gas, electricity, and fuel oil, U.S. city average and selected areas will no longer be published." By chance did you notice any rational for the change? __My suggestion for new metrics to track core inflation are 1) the cost to accomplish doing laundry and 2) under "Medical care services" a sub category entitled Insurance for a few types of coverage- vs. just tracking the costs of providing services once they are consumed. __

kakatoaFebruary 23rd, 2013 at 3:27 pm

Out in my neck of the woods, Sierra foothills, the housing asset bubble is stabilizing and we have even seen a bit of an uptick in the median price for homes. Our country assessors office will be thrilled and even more importantly for households in the area there is a hope that some new home and commercial development occurs as the debt load required to upgrade and expand capacity by the local water purveyors- both incoming and outgoing water and waste- in my area has led to lots of interesting ways to allocate the cost of the debt. Spreading the debt load by a bigger n would help minimize the local politics which has been causing a fair amount of conflict between the different groups of users. Each group has a slightly different interpretation of what is a fair cost allocation for the products (water) and services (sewer) that they use.

kakatoaFebruary 23rd, 2013 at 3:28 pm

I have had a few interesting discussions with owners of Laundromats around the state (urban, suburban and rural areas), to get a feel for how they price their services to meet their customers desire for clean clothes. It's a bit amazing how much energy you get for your quarter to dry clothes around the state. 15 minutes of dry time for the quarter was the least expensive (LA), the highest cost was matched by a few rural areas in the state- 6 minutes of dry time for a quarter. The costs to wash a load of laundry varies a lot as well. $1.50 for a traditional top loader to $2.50 a load. Hence if we start tracking laundry costs we can smooth out the ups and downs in energy cost and get a feel for the costs to provide base water and sewer services.

kakatoaFebruary 23rd, 2013 at 3:29 pm

With the move towards mandatory health care insurance, tracking a few normalized insurance packages seems like a good way to track what is happening in health care costs. I personally botched my previous estimate of the costs of base health care insurance plans. I planned for 10% increases per year, unfortunately the actual increases have been pushing 20% per year for the last 4 years.

Ed Dolan EdDolanFebruary 23rd, 2013 at 4:50 pm

I agree, since most people purchase healthcare services in the form of insurance, intuitively the premium is what they think of when they think of that part of the cost of living.

SierraFebruary 24th, 2013 at 1:47 pm

I Too live in the "Sierra Foothills"……
obviously those who make the decisions about what to count and or not in the "CPI" don't do any real life shopping just for necessities….
remember when GW Bush (the first) was asked what the price of milk was?
Like a deer caught in the headlights of an oncoming train!
And, I'm sure those who make those "CPI decisions" mostly have decent health care insurance…..
Many of us who have worked hard for 50-60 ( yes those numbers are correct) years and retired with small pensions plus SS are being literally crushed by the Feds "ZIRP" policies…..while too many fraud steers are living the good life.
So please let's get real about what is CPI and what is not……

kakatoaFebruary 25th, 2013 at 10:21 am

It will take awhile for the costs of our, CA's, Cap and Trade system- AB32 to translate into higher costs for products and services. I did noticed that our second auction had prices higher then the first auction-

"The market clearing price for a “current” vintage 2013 allowance was $13.62, nearly $3 above the auction reserve price of $10.71."

I finally found out that yes propane is going to fall under the CAP and Trade program. The market will start in 2015. I was considering alternatives to my rather expensive to operate electric dryer. It looks like I have to consider an additional cost input for my already volatile propane costs when I evaluate switching fuels/energy sources to accomplish the task. As I don't have natural gas, I completely forgot to check to see if it is included in the AB32 program- I know it is for the large electric utilities I just forgot to get verification how natural gas used for residential HVAC, hot water and as a transportation fuel is, or is about to be, managed/regulated.

kakatoaFebruary 25th, 2013 at 10:31 am

It seems I am unable to be conscience enough to keep my comments (thoughts, insights-? this one is debatable!, clarifications, etc.) into the allotted space. My better half is my editor and she isn't going to help me out in this format. But a final thought on alternatives-

One advantage of living in the foothills, at my elevation that is, is that we are out of the fog and mostly out of the snow. Having already verified that my location is ideal for PV, as in our current PV system's capacity factor is as good as it gets, it looks like I will get to look into adding some additional PV capacity vs. switching my energy source for accomplishing our laundry chores.

jack strawFebruary 24th, 2013 at 7:32 pm

on a roll keep it coming. i think we may be heading towards some type of "Japanese scenario" where we simply can't get out from underneath the massive asset purchases we are now engaging in try as we might. we also could be in for a prolonged bout of disinflation if not outright deflation as the inability to raise prices while the consumer remains tapped out "forever" simply becomes the New Normal. we have yet to have the wave of defaults…but you could get an old fashioned tax revolt as "this is part of the cost equation for living" and the bottom line is wages have collapsed and benefits with them. amazingly "it's worse in Europe." parts of the USA have a lot going for them. in the case of North Dakota they never even felt the recession…but that's after thirty years of being in one so if you're looking for a time frame…there you go. I think other states in the USA are going to be rock stars here as well. I've stated this elsewhere so i will state it again…Pennsylvania, Texas, the Upper mid-west in general, hopefully New Hampshire, hopefully Maine. Alabama. hopefully Oklahoma. hopefully California. the whole pacific northwest. we shall see. the Fed has moved heaven and earth here…and the Federal Government has not truly cut back…nor is it about to. but there is no shortage of a need for every buck to be used to its maximum effect now. the Fed has obviously taken more cash out of circulation than at any time in history in order to effect QE. clearly it has failed in its task of getting the economy growing again. is there any other choice now?

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