Comment 31: Correlation among interest rate, inflation and economic growth in the globalization and pre-globalization eras. (July 3, 2006)

Note (June 2, 2010): A detailed discussion of the relation between interest rates and inflation in the context of testing the ability of "Bond Vigilantes" to foresee inflation trends and recessions is presented in article 14.

Note (March 15, 2008): A more complete discussion of US inflation from 1960 to 2007 is contained in Section 3 of article 10.

The speculations about what US FED (The Federal Reserve Board of USA) will or will not do about the short-term interest rate have caused the violent gyrations of global equity, financial, commodity and currency markets. Those gyrations have been based on how to interpret the nuance of the speeches given by the new FED chairman or to read the meaning between lines of FED statements. It shows vividly that free markets really do not know what is in store in future, a sharp blow to the myth propagated by some financial analysts and observers that "markets" know best. In order to correctly gauge the current economic conditions and then project the future course of US economy, including the direction of interest rates and inflation, we must analyze available economic data objectively and logically, and treat economics as a real science, not as a collection of unchecked dogmas and wishful thinking. However, to rely on data does not mean that we should be jumping around with the release of every data. After all how to pierce through the noises and statistical fluctuations, to reveal the underlying true trends and properties, and then to explain the uncovered trends and properties with logic are the essence of a hardcore science.

In Comment 23 we have discussed how FED has lost some influence to cause an economic recession by raising short-term interest rates since the onset of the globalization processes. The phrase uttered by many analysts that six out of eight most recent recessions started within two years after FED started to raise short-term interest rates only applies to six recessions before the era of globalization. Two recessions in the globalization era came many years after the start of interest rate raising campaign of FED. There were also FED interest raising campaigns that did not induce recessions. It is argued in Article 2 and Article 2A that the ebbs and flows of trade deficit, or equivalently the ups and downs of foreign capital inflow, become increasingly more potent in regulating US economy than the FED action alone. In Comment 30 we have analyzed the recent inflation trends. The growth rate of consumer price index (CPI) is in a steadily rising trend. Even if CPI has one or two quieter monthly readings, the up-trend is not going to be broken. Contrary to the wish of many analysts, rising CPI always seeps through into core CPI that is the price index excluding energy and food prices, with a delay of 6 to 12 months. This means that core CPI will continue to rise through 2006 due to the heightened CPI through the late 2005 to early 2006 irrespective of the behavior of CPI in near future. Since core CPI is a substantial lagging indicator, we will not discuss it further in this comment. In order to catch a complete picture of US economy, in this comment we will combine interest rates, inflation and the growth rate of economy, and will study how the correlations among those three factors change as the globalization process sets in.

In the figure at the right, real GDP (black dots) and CPI (red dots) are plotted with semiannual intervals from 1947 to 2005. Both graphs are plotted in logarithmic scales so that if a set of data lies along a straight line, then the data points are rising or falling with a constant rate. Real GDP data shown in the graph are adjusted for inflation with the price index of year 2000 taken as 100%. The early part of 1980's is the dividing period; before that time it was the pre-globalization era, and after that time it has been the era of globalization. For 30 years from 1950 to 1979, real GDP grew about 3.8% a year in average. For 23 years from 1983 to 2005, real GDP grew about 3.4% a year in average. Though the growth rates of real GDP do not show huge differences during the pre-globalization era and in the globalization era, the behavior of CPI is vastly different. During the pre-globalization era under consideration, CPI turned into a hyperinflation by the end of 1980's. This indicates that US economic structure at the pre-globalization era cannot support an average real GDP growth rate of 3.8% a year without kindling inflation. On the other hand in the globalization era, the growth rate of CPI has slowed down to a sustainable pace like 3.4% a year in average, similar amount as the average growth rate of real GDP.

The first thing that we need to do is to explain the marked difference of the behavior of CPI in the globalization era from the time of pre-globalization. The pre-globalization period was the golden age of organized labor. Many workers joined labor unions, and the unionized labor contracts usually contained the clause of inflation indexing; as inflation rises, wages of union members rise automatically according to a formula written into the labor contract. As inflation starts, wages go up automatically. The increased labor cost in turn pushes up the price of manufactured goods and thus fuel inflation. The heightened inflation rate increases wages and then fuel more inflation and so on. Thus a vicious cycle of higher and higher inflation is formed. The hyperinflation of the late 1970's was the manifestation of this self-accelerating inflation mechanism. As globalization process takes hold, high cost manufacturers are forced out of businesses. They are replaced by domestic businesses relied on non-unionized labors, or are replaced by factories in the developing worlds with rock bottom labor costs. Organized labor force has been in steady decline and the vicious self-inflationary structure of inflation indexing is disappearing fast. That is why CPI is rising with a more or less sustained constant rate since the era of globalization dawned.

On top of the general inflation calming factor due to the globalization as discussed in the previous paragraph, there are two unique factors of globalization that push up or slow down inflation. The first factor is the ebbs and flows of massive trade deficit. The globalization process has ushered in the era of run away US trade deficit. As discussed in Article 2 and Article 2A, the ups and downs of trade deficit are regulated by the ups and downs of the exchange rate of US Dollar against the currencies of its trading partners. Major movements in the exchange rate of US Dollar take about 2 years to be translated into the movements of US trade deficit. When US trade deficit explodes, the onslaught of imports tends to hold down the consumer price level in USA. On the other hand when US trade deficit shrinks, the consumer price level moves higher. Those effects are visible in the CPI graph (the red line) in the figure. From 1984 to 1986 US trade deficit experienced the first phase of explosion, and the growth rate of CPI was reduced. The vast devaluation of US Dollar against Japanese Yen starting in 1985 caused US trade deficit to shrink, from 1987 to 1990, and inflation picked up as shown in the CPI curve. From 1991 US trade deficit started to expand again, and the growth rate of CPI moderated accordingly until 1997. The super low interest rate policy of Japan in 1995 had initiated massive Yen carry trades and thus boosted the value of US Dollar sharply higher against Japanese Yen as discussed in Article 1. This highflying Dollar then made US trade deficit explode further from 1997, and CPI growth rate moderated further as shown in the CPI curve. However, there is a side effect of trade deficit that complicates the inflation picture. Expanding trade deficit means expanding foreign capital inflow since US dollars are handed over to foreigners when USA imports goods, and those dollars in the hands of foreigners will eventually all flow back to US financial markets as foreign capital inflow. The massive foreign capital inflow will stimulate US consumers to borrow more and spend more. If the stimulative effect of foreign capital inflow is strong enough to the degree to cause wages in the service sectors to rise, and if this inflationary effect becomes stronger than the inflation suppressing effect of the onslaught of imports, inflation in US will pick up as trade deficit expands (equivalently as foreign capital inflow increases). When the trade deficit shrinks, so is the foreign capital inflow. The reduced foreign capital inflow will trigger a rout in stock markets as demonstrated in the crashes of 1987 and 2000. If the stock market crash causes consumers to pull back and ushers in a recession, inflation will become tamer as trade deficit shrinks. From 1999 to the first part of 2000, the explosion of foreign capital inflow boosted stock prices skyward and thus increased US inflation rate. When the bubble burst as the trade deficit and the foreign capital inflow slowed, the consequence of 1998 US Dollar collapse vs. Japanese Yen, US consumers retreated from the spending crazy and US inflation calmed down as visible from the CPI curve. The 1987 stock market crash did not induce a consumer spending slow down, so there was no 1988 recession and also the above-mentioned side effect of shrinking trade deficit to calm inflation was not realized. For the reason of the absence of an immediate recession after the 1987 stock market crash readers are referred to the discussion included in Article 2A and the analysis later on in this comment.

The second factor that pushes up inflation in the globalization era is the rising raw material prices, especially the price of crude oil. As has been discussed in Comment 28, the current globalization scheme is totally dependent on the run away US trade deficit that helps USA to continue its borrow and spend boom on one hand and allows China to run an explosive growth by exporting to USA. As China becomes the factory of USA, slight improvement in living standard of it's huge and still poor population strains the global resources, especially petroleum resource. This factor becomes the major reason of sustained very high crude oil price. The drastically escalated crude oil price is in turn the main reason of steadily advancing inflation pressure in recent years. US trade deficit is showing some degree of stagnation in recent months, due to the sharply lower Dollar vs. Yen and Euro in the spring of 2004, but Chinese Yuan was still pegged to Dollar at that time. So China's exports to US is continuing its impressive expansion by eating into the share of other more energy efficient entities. The growth rate of China's real GDP in 2006 is estimated to top 10%. Thus the price of crude oil is not likely to fall in foreseeable future and the inflation pressure in US will continue as has been pointed out in Comment 30. As energy prices soar further, the advantage of energy inefficient China will be balanced off with the disadvantage of other energy efficient export-oriented entities, exports from China will reach a plateau and the prices of energy will level off eventually. However, that equilibrium price level of energy is probably substantially higher than the present level.

Let us introduce interest rates into the picture so that we can derive some quantitative estimates. The interest rate that we are going to concentrate on is The Federal Fund's rate. This rate is the interest rate of overnight inter-bank market in which financial institutions lend and borrow money to one another for a 24-hour period. The Federal Fund's rate determines all the short-term interest rates like the rate on CD's, prime rates and so on. FED targets this Federal Fund's rate. If FED wants to tighten, it will withdraw liquidity from the inter-bank market and forces the rate to go up, and vice versa. In the top portion of the second figure at the right, The Federal Fund's rate is represented by green dots, and is plotted semi-annually from 1955 to 2005. Red dots are the annualized growth rate of CPI, also plotted semi-annually. Through 1960's The Federal Fund's rate was kept above the growth rate of CPI, but was not enough to fend off inflation to creep in by the end of the decade. The accelerating inflation then forced FED to raise The Federal Fund's rate sharply higher to induce the recession of 1969 to 1970. As the recession hit and inflation subsided, FED lowered The Federal Fund's rate too soon and too much. This mistake induced an even more explosive surge of inflation from 1972 to 1974, and required The Federal Fund's rate to rise sharply. As the 1973-1974 recession hit and inflation subsided, FED repeated the practice of lowering The Federal Fund's rate too soon and too much. Thus the second leg of hyperinflation took hold and ended at the twin recessions of 1979-1980 and 1981-1983 along side with the second energy crises. After the globalization era dawned, disinflational mechanism has started to work whereas FED kept The Federal Fund's rate substantially above the growth rate of CPI for most of the time. After the 2000-2001 economic slowdown, FED lowered The Federal Fund's rate aggressively and kept it below the inflation rate for 4 years, an unprecedented event for the past 50 years. We are tempted to think that the recent uptrend of the inflation rate is the result of this too accommodative monetary policy. However, the discussion so far is still more qualitative than quantitative since we do not know exactly how to measure the tightness of the monetary policy of FED and how it serves as the leading indicator for the inflation to come. Apparently we need some better ways to look at the picture than the graphs in the top portion of the figure.

When the amount of financial transactions is rising, financial institutes are more likely to encounter needs to borrow from fellow institutes to bridge temporary shortage of funds, and thus The Federal Fund's rate will be pushed up. When the economic environment is cool, less financial transactions will be undertaken and we will see a lower Federal Fund's rate. The activities of transactions in the economy can be measured by the nominal GDP that is the GDP number not adjusted for inflation. In the middle portion of the second figure the annualized growth rate of nominal GDP is plotted as black dots, again in semi-annual intervals. The Federal Fund's rate of the top portion of the figure is re-plotted as green dots. There are considerable degrees of synchronization between two curves, but not a total coincidence. When the growth rate of nominal GDP is above The Federal Fund's rate, monetary constraint is weak and economy will expand. When the growth rate of nominal GDP is below The Federal Fund's rate, monetary condition is tight. Thus we can devise an indicator, called the "monetary indicator" here, as the annualized growth rate of nominal GDP minus The Federal Fund's rate. When this monetary indicator is positive, monetary condition is stimulative, and when this indicator is negative, monetary condition is restrictive. In the bottom portion of the second figure, the semi-annual average of this monetary indicator is plotted as blue dots, whereas the growth rate of CPI as depicted in the top portion of the figure is re-plotted as red dots. The scale of the monetary indicator is shown in the left hand side of the graph, and the scale of CPI growth rate is shown at the right hand side of the graph. We can see that from the late 1950's to 1968, monetary condition was loose most of the time, and thus ignited the inflation surge near the end of 1960's. As FED tightened the monetary condition abruptly in 1968 and 1969 to calm the inflation by inducing the 1970 recession, inflation cooled down with the recession. Then FED immediately returned the monetary condition to very loose status and had ignited the first phase of hyperinflation from 1972 to 1974, capped with the first energy crises. As the first phase of inflation spiral arrived, monetary condition was again abruptly tightened, introducing the 1973-1974 recession. As inflation pressure eased somewhat with the 1973-1974 recession, FED again hurriedly relaxed the monetary constraint, and thus invited the second phase of the hyperinflation. To quench the run away hyperinflation, FED adopted a super tight monetary policy for almost 4 years, starting from late 1978, and thus broke the back of the hyperinflation. As the globalization process set in and the disinflationary force has come into play as discussed in the first part of this comment, inflation pressure eased, FED kept monetary condition at neutral for a while, and allowed the economy to expand strongly riding on the first phase of exploding trade deficit. Only when US trade deficit peaked at 1987 and then started to shrink, inflation started to heat up again as discussed before. FED tightened as inflation flared up near the end of 1980's. With the help of shrinking trade deficit and a tight monetary policy, a recession of 1990 to 1991 finally set in and inflation pressure eased again. FED loosened the monetary policy substantially when inflation calmed down. This time inflation did not flare up due to the renewed expansion of trade deficit, even with a very accommodative monetary policy from 1992 to 1994. FED tried to tighten in the latter half of 1994 to 1995 apparently from the fear of rapidly falling Dollar at that time, but a recession never materialized thanks to the continuously expanding trade deficit. As US trade deficit exploded further from 1997 due to the super low interest rate policy of Japan that spurred massive Yen carry trade and sky rocketing Dollar as discussed in Article 1, inflation rate eased further. FED was cautious and kept monetary policy only slightly accommodative, allowing US economy to advance on the tide of exploding trade deficit. As US economy super-heated by the ever-rising trade deficit and the escalated inflow of foreign capita in the period of 1999 to 2000, the stimuli from rapidly expanding foreign capital inflow overwhelmed the rapidly expanding imports, so inflation started to tick up, and FED started to tighten again. As the recession of 2000-2002 arrived due to the shrinkage of trade deficit, the result of 1998 Dollar collapse, in conjunction with the modest tightening of FED, inflation retreated and FED turned to aggressive easing again. This massive FED easing in conjunction with renewed expansion of the trade deficit, accompanied by massive foreign capital inflow, formed the base of plentiful money that fanned the recent real-estate bubble; US consumers went into spending crazy by borrowing heavily from their houses through mortgage refinancing and various innovative refinancing schemes that were invented by financial institutes from the desire to get rid of accumulating funds in their hands. The massive FED easing pushed Dollar down sharply, and forced Japanese government to enter the currency market to buy up 400+ billion dollars from the fall of 2003 to the spring of 2004 in order to keep Dollar overvalued and US trade deficit continue to explode. That artificial stimulus based on the massive global trade imbalance finally rekindled inflation through the exploding raw material prices as discussed before. Seeing this renewal of inflation pressure and the exit of Japanese government from the currency market in the spring of 2004, FED has been forced to tighten since the middle of 2004. Through the discussion of this paragraph, it should be obvious that the usage of the monetary indicator and its correlation with inflation rate is more advantageous than the direct comparison of The Federal Fund's rate and inflation rate as done in the top portion of the figure. For example, according to The Federal Fund's rate graph, the rate started to rise from the beginning of 1961 and continued to rise for six years without seeing a recession. Thus if we concentrate on The Federal Fund's rate, it becomes a conundrum. However, the monetary indicator graph shows that the monetary policy was quite accommodative from 1961 to 1966, and that was why a recession never materialized in spite of continuously rising Federal Fund's rate in that period. The same can be said about the rise of The Federal Fund's rate from 1993; the monetary indicator says that the monetary policy was accommodative at that time so a recession was not induced. Only when the monetary indicator turned to restrictive at the same time that the stimulus from expanding trade deficit waned, then a recession followed.

Now we are equipped with the measures required to project the future course of The Federal Fund's rate and inflation. As mentioned before, the economic expansion of China based on its ever-expanding exports has no sign of slowing down. This will continue to put pressure on the prices of raw materials, especially on the price of crude oil. Thus inflation pressure is not likely to subside soon. In order to prevent the ignition of another round of run away inflation, FED needs to bring the monetary indicator down to neutral level or even slightly below the neutral point. Since the monetary indicator is the difference between the growth rate of nominal GDP and The Federal Fund's rate, how high The Federal Fund's rate needs to go depends on the growth rate of nominal GDP. From the second half of 2003 to the second half of 2005, nominal GDP grew at the upper half of 6% range in average as is evident from the middle portion of the second figure. The first quarter of 2006 saw a sizzling growth of nominal GDP, about +8.7%. Naturally the growth rate of the second quarter of 2006 will subside considerably from the sizzling first quarter pace, probably to about 6 to 7% range. Assuming that the growth rate of nominal GDP will hold at that range, the neutral monetary indicator means that The Federal Fund's rate needs to move up to 6 to 7% range. If the monetary indicator is held at the neural point, inflation probably will continue to run around 4 to 5% a year, leaving real GDP to grow at an annual rate of about 2 to 3%. However, if the growth rate of nominal GDP in the second half of 2006 is above the 6 to 7% range, The Federal Fund's rate needs to move above 7% to prevent a renewed inflation surge. Only if the growth rate of nominal GDP in the second half of 2006 is below 6% by a significant amount, that is, a recession since real GDP will stagnate or shrink, The Federal Fund's rate can stay at the present 5.25% level. Considering the fact that the monetary condition is not really tight at present, and the absence of prior Dollar movement that will imply a contraction of US trade deficit in the second half of 2006, we do not expect a recession will be realized in the second half of 2006, so The Federal Fund's rate needs to move up to 6 to 7% range to prevent a later inflation surge. If the rate fails to move up to that level, inflation will be worse in 2007 and requires a much more aggressive monetary tightening to calm it down. If that "much more aggressive tightening in 2007" is also not done, Dollar will move sharply lower against the currencies of its trading partners, US trade deficit will shrink in about 2 years in the future and a full blown recession will arrive in 2009.