Expectation Anchors Aweigh

Daniel beat me to the punch on Simon Johnson's latest writing, but hopefully he won't mind if I add a few additional thoughts. As Daniel notes, Johnson is worried about inflation, primarily because he thinks America has become a lot more like an emerging market than your standard developed nation. Johnson writes:

As [Bernanke] sees the world, there is only one course of action remaining: print money and hope for a moderate degree of inflation. The money part was, of course, the announcement yesterday from the Fed.

The inflation part is a leap of faith. If inflation is driven by the so-called "output gap," i.e., how far the US economy is below potential output, then prices will not increase much, the yield curve steepens moderately, and banks make out like bandits (it's just an expression).

But if the whole world is moving more into an emerging market-type situation then (a) inflation expectations become deanchored (central bank jargon for "really scary"), (b) potential output falls as we massively deleverage, and (b) people move increasingly into alternative assets - storable commodities spring to mind - and we get some serious inflation.

If oil prices jump, then we have an even bigger inflation problem. Oil is not storable, supposedly. But if you can explain to me exactly why oil prices rose as they did during the first part of 2008, despite the slowing global economy, I might be greatly reassured that we are not heading immediately into a runaway inflation spiral.

This could use a little pulling apart, I think. In his rampant inflation scenario, there are actually two stories at work. One is the emerging market dynamic, where consumer inflation expectations become deanchored and consumers pile into storable commodities. This would be very worrisome, if true. Another involves the question of potential output, which could create inflation pressures without any shift toward Banana Republic status taking place.

In that case, the story would go something like this. The Fed is used to thinking about an America with a natural rate of unemployment around 5%. The last few years have resulted in a lot of economic destruction, however, primarily in the financial and housing sectors, such that the current natural rate of unemployment is closer to the 7% or 8% mark. If the Fed eases thinking that we have more slack in the economy than is actually the case (the difference between the current unemployment rate and 5%, rather than the difference in the current unemployment rate and 7%) then it will wind up overshooting, and inflation will result. In this story, too low rates might easily lead to commodity investments, as well as unsustainable demand growth, also leading to rising commodities prices.

In this latter case, there need not be any move toward emerging market status, and there need not be any deanchoring of expectations. And in fact, it would seem that this scenario describes last year's commodity price spike fairly well. During that episode, expectations proved to be strongly anchored -- core prices hardly moved while food and energy prices soared.

That doesn't mean that expectations would have remained anchored forever, had recession not gutted global demand. Neither does it mean that inflation and rising oil prices aren't a threat. It does suggest to me that Johnson's description of America is not yet the most accurate picture available.