Saturday, January 29, 2005

Inflation? Part 2

There was quite a buzz last week about the 4Q GDP report. The headline number, 3.1% annualized, was lower than many people were expecting, in part because inventory accumulation was lower than expected, but more importantly because net trade took of 1.73 percentage points from the headline rate.

There are many different ways of looking at this number. Some will tell you that it was weak and focus on the headline figure, and others will instead emphasize that domestic demand is still humming along quite nicely, with consumption rising 4.6%, and investment almost 10%.

The truth is that those consumption and investment number are pretty strong indeed. What's to blame? I would highlight extremely loose monetary and fiscal policy, which is stimulating demand quite vigorously still, despite the Fed's timid rate hikes.

Luckily, this dramatic demand is meeting plenty of supply from abroad at current prices. (actually, import prices are rising at about 10% per year, but this could be a lot worse) The reason supply is available for so cheap is that, as brad setser has been emphasizing and explaining in his blog, Asian (and some other) central banks have been piling up US dollars in order to keep their currencies cheap.

Most people who think about these issues (for a some good sources see my previous link on the US current account) agree that the dollar is going to fall significantly. You can think of the dollars' plunge as a massive supply shock. Things that used to be available in infinite amounts at current prices suddenly cost much more.

This would not be inflationary if the policy mix (monetary and fiscal policy) were tightened in order to keep demand in check. However, I somehow doubt that will happen. The White House loves to spend and hates to tax, and the Fed is way too chummy with the administration.

To me, the most likely result of all this is inflation, as policymakers will choose to accommodate the pressures stemming from the supply shock I've described above rather than be blamed for causing a recession.

TIPS seem like a good idea


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