Python Snake Julius Squeezer Helps Explain Inflation Perils

In a speech today (August 19, 2008) at the Progress & Freedom Foundation Aspen Summit 2008, Richard Fisher, the President of the Dallas Federal Reserve Bank discussed his views on the economy and inflation. What I thought was most interesting was how he discussed the perils of rising inflation even in a recessionary environment, otherwise known as stagflation.

He explains why the Fed is so concerned about inflation:

"As for the “noninflationary” part, the observer would take heart from the recent price reversals that have taken place in the oil and commodity markets. But her brow might knit up a bit as she dissects the Consumer Price Index (CPI) data released Thursday. That report said that consumer inflation increased at an annualized rate of 10.3 percent in July and that, year over year, consumer prices have risen 5.5 percent. She might also note that roughly 25 percent of our Consumer Price Index is a theoretical construct to capture the cost of shelter called “owner’s equivalent rent” and conclude that the effective cost pressure on consumers and business operators is actually higher than the headline number.

And our clear-eyed woman would note that even as economists remove energy and food from the CPI to eliminate the “noise” of those volatile items, the underlying, or “core,” inflation measure is also drifting upward on a year-over-year basis, indicating that inflationary pressures are spreading beyond energy and food prices. Were she an economics wonk, she might further note that the “trimmed mean” CPI that the Cleveland Fed calculates—another way to parse the data to look for the underlying trend—posted a one-month gain of 7.2 percent, something it has only done once before, in 1991."

He then quotes Martin Feldstein, who wrote that in the Financial Times that the:

"Federal Reserve “is prepared to gamble that the weakness in U.S. employment and the general decline in economic activity will prevent a wage-price spiral without further increases in the interest rate. If food and energy prices remain at today’s level and wage costs do not accelerate, the overall consumer price index inflation will decline by next year"

He agrees with this statement. Clearly, the Fed is hoping that slower growth and the recent drop in commodity prices will be enough to prevent the spread of inflation.

He then uses an analogy of a python snake to explain the two ways the economy could handle inflation:

"Because this is a serious speech, I will refrain from telling you about my neighbor in Dallas who had a pet python named Julius Squeezer. But I will tell you that I learned much from watching that python over the years: He was an efficient processor of most anything he swallowed, although there were times when he had to be taken to the vet to be treated for indigestion.

It is tempting to deduce from the recent reversal of commodity prices—in particular, energy prices save coal—that the discomfort manifest in headline inflation numbers that we broached in July is passing through the system and is being squeezed out by slowing economic growth. This is certainly a plausible economic scenario. Weakness in the U.S. and other advanced economies will mitigate inflationary pressures, rendering them a temporary inconvenience. In the parlance of central bankers, the recent run-up of headline and core prices represents “noise” rather than underlying “signal.” Given that the Fed focuses on signals about intermediate and long-term sustainable, noninflationary employment growth, rather than short-term expediency, it is in keeping with our charter to give considerable weight to this scenario.

I note that we would not be alone in doing so. This is the conclusion that the Bank of England has been most public about as it recently ceased raising its policy rate. I have the highest personal regard for Governor Mervyn King and especially for his deputy, a member of the distinguished advisory board of the Dallas Fed’s Globalization and Monetary Policy Institute, the convivially named Mr. Charlie Bean. I did note, however, that in reaction to the recent release of the Bank of England’s analysis, the Financial Times on Thursday wrote an especially harsh editorial titled “Shoot the Doves,” which concluded with these words:

“The ongoing disruption in credit markets is acting as a brake on the economy … because credit is less available and it costs more .… Keeping rates on hold looks right for now.”

“But,” the editorial went on, “… the Bank must also worry about its credibility: if the public ceases to believe that it will bring inflation back down, then it will become much harder to do so.”[2]

This risk applies to the Fed just as much as it does to the Bank of England. We cannot afford to gamble away our credibility. That is why the FOMC has made it clear in its recent statements that we are keenly monitoring inflationary impulses. In doing so, we must be wary of a second possible scenario, one that differs from the one summarized by Dr. Feldstein.

This second scenario is less felicitous. It acknowledges the manic-depressive nature of commodity markets and recognizes that it was inevitable that price peaks would give way to price valleys. But the scenario envisions the possibility that rather than passing through the python, the recent burst of cost-push inflation is giving the beast digestion problems that might manifest themselves in the form of a lingering inflationary fever."

Which will it be, the efficient python or the bloated one? Will inflation pass through or will it stick and cause more problems? My bet is that if the economy stays weak it won't be a problem. I don't know anyone getting a raise or even expecting one. As unemployment increases people will just be happy to have a job. But time will tell.