A Kind Word for Inflation  

Paul McCulley at Pimco has an interesting article on the wave of inflation that is about to break, saying that it is inevitable and people shouldn't get too excited about the prospect of negative real interest rates, as both capital and labour need to suffer together. A remarkably progressive (albeit realistic) attitude for a bond fund manager - although I don't think too many Libertarians would read it without gnashing their teeth - maybe I should send it on to the guys at The Daily Reckoning and await the explosion...

From A Kind Word for Inflation:

No, I have not lost my mind. I’m fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don’t tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed’s comfort zone. Needs, you ask?

Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation’s terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below tells that simple story.

Americans are working more hours for the same barrel of oil. That is a negative real terms of trade shock. Put differently, we are less rich or more poor than we were before oil prices took off. There is no getting ‘round this. In turn, there is no escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment. The question of the hour is how this pain should be apportioned. Last week, Fed Vice Chairman Don Kohn provided the right answer, presuming there is a right answer:

“… an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.”

Mr. Kohn was preaching the raw, honest truth: a surge in oil prices raises the Misery Index, temporarily lifting both inflation and the unemployment rate. In turn, those outcomes beget lower real wages and, presumably, lower real profits, too. We are less rich or more poor – period. Thus, those who holler and scream at the Fed for letting the inflation genie out of the bottle need to calm down. A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money. ...

In the wake of a negative terms of trade shock, all factors of production should absorb a negative hit to their real returns. If indexing to headline inflation is inappropriate for labor wages and capital’s profits, why should cash yields be indexed by the Fed?

And what if holders of cash don’t like it? Then they can step out on the risk spectrum. After all, a basic of capitalism is no risk, no reward. And temporarily higher inflation in the wake of a negative terms of trade shock is an efficient lubricant for the economy to make the necessary real adjustments.