Sunday, February 26, 2023

Stubborn PCE: What is "Sticky Inflation?"

Click here to read the original Cautious Optimism Facebook post with comments 

3 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff offers some color analysis explaining what most news stories reporting “sticky inflation” won’t.

So despite the Federal Reserve’s recent campaign of rapid interest rate hikes, and a great degree of success stopping growth of the money supply in its tracks, the January PCE inflation numbers were still elevated. Month to month headline and core were both up 0.6%.

Although inflation numbers vary greatly from one month to the next, a core month-to-month of +0.6%, compounded over twelve months, translates to an annual inflation rate of 7.4%.

Both are still far higher than the Fed’s 2% inflation target.

(1.006^12 = 1.0744 = +7.44% inflation)

Read more on the PCE report at Bloomberg:

So if the money supply is no longer growing, and in fact has actually contracted by 2.2% over the last three quarters, why are prices still rising at a 7.4% clip?

Many business news articles are now blaming “sticky” inflation, but few really explain what’s causing price increases to be sticky in the first place.

Well the Economics Correspondent fingered the potential culprit two months ago, and new data show it’s still to blame: rising monetary velocity.

As we prove it using junior high math, the Correspondent can’t stress enough how valuable the Equation of Exchange is for understanding what causes inflation.

mv = py

Where m = the money supply, v = monetary velocity, or how many times each dollar of the money supply is spent each year, p = the price level, and y = real GDP or the dollar value of all economic transactions in the economy.

If we isolate (p) to understand what makes prices move we get:

p = mv/y.

So if the money supply falls, prices fall. If the quantity of goods and services in the economy grows, prices also fall.

Both have happened the last three quarters (St. Louis Federal Reserve source links are below). From 22Q1 to 22Q4:

-The money supply measured by M2 contracted from $21.846 trillion to $21.363 trillion or -2.2%

-GDP has grown—barely. From 22Q1 to 22Q4 real GDP rose from $19.924 trillion to $20.198 trillion or +1.4%.

Therefore if velocity were constant prices should have fallen the last three quarters by 4.3% (0.978/1.022 = 0.957 or -4.3%).

But they haven’t fallen. They’re still rising.

Two months ago the Economics Correspondent wrote he was concerned about the last variable, M2 velocity, which had risen Q1 to Q3 from 1.14 to 1.19, an increase of 4.39% in half a year.

Compounded over a full year such an increase would equate to a 9% annual increase in prices, and the Correspondent argued the Fed sees this, is probably concerned about it, and is still raising rates because of it.

Well, we have a new quarter of velocity data and the trend is confirmed. In Q4 M2 velocity reached 1.226.

So from Q1 to Q4 velocity increased from 1.14 to 1.226 or up 7.5% which, when annualized, translates to an even worse yearly inflation rate of 10.1%.

Of course velocity is being partially offset by falling money and barely rising GDP, so when we plug all three variables into the equation we get our final nine-month inflation rate:

(0.978 x 1.075)/1.022 = +3.7% inflation.

Extrapolate that out one more quarter for a full year and the Fed is looking at an annualized inflation rate of +5%. That’s lower than the implied January number, but consistent with the Fed’s worries about inflation persisting despite its success slowing and even slightly reversing money supply growth.

And what’s causing velocity to rise? Monetary economists blame “inflation expectations.” That is, inflation itself changes consumer and business behavior, both of whom start moving their purchases forward to buy stuff before it gets more expensive. When consumers and businesses move purchases up the rising velocity itself pushes prices up even higher, leading other consumers and businesses to spend even faster and a vicious cycle can ensue.

The Fed wants to squash those inflation expectations and stop the growth in velocity.

And that’s why it’s still tightening even as the money supply has been falling.

Source data:

1) Q1 to Q4 M2: $21.846T to $21.363T

2) Q1 to Q4 real GDP: $19.924T to $20.198T

3) Q1 to Q4 M2 velocity: 1.14 to 1.226

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