Inflation, Interest rates, and Bank Profits
There really isn’t much to say about today’s report on consumer price inflation: it isn’t an issue. The overall increase came in at 0.2% in January which marks the fifth straight month we have experienced that level of price increases. For the last twelve months as a whole inflation has been only 2.6%, right in the range the Fed is trying to manage towards. The most interesting aspect of today’s news was the so-called ‘core inflation’ figure – that’s the one with the volatile cost of energy and food stripped out – dropped by 0.1%. This is the first monthly decline in the core number since 1982, and shows that there is no evidence of inflationary pressure building in the economy.
This is hardly surprising given the massive under-utilization of resources that characterizes the economy right now: there clearly is no room for businesses to increase prices. The only pressure that could have developed would have been in import prices as the dollar moves, but the turmoil in Europe has put an end to that temporarily. Until the economy gets going at a more rapid rate there simply is no source of great inflation, which implies that the is an equal absence of short term, pressure on interest rates.
Over the longer term the outlook for inflation remains pretty much what we have now. The recovery is not strong enough to engender fears of inflation from the normal sources, notably wage growth. With the overhang of unemployment as it is, wages are not going to grow out of hand any time soon. The other source of price pressure, the one most often commented on in the press, is the huge monetary increase the Fed provided in order to offset the collapse of economic activity the last two years.
This money supply ‘problem’ has been much discussed as a destabilizing force once the economy starts growing.
I don’t agree with the ‘doomsday’ talk.
Inflation cannot emerge, even from such a massive build up in money, when there is so much slack in the economy. The notion that there will be ‘too much money chasing too few goods’ is not applicable when businesses are facing such fierce competition and consumption is so weak. Since we are likely to be facing such a combination of factors for many months, if not years, there is ample time for the Fed to drain away the extra reserves that could cause a problem. Now is not the time for any form of tightening, so any talk of such a draining is way too premature, but the Fed signaled the end of its easy money period yesterday by raising the discount rate. This is a much less significant rate than the Fed Funds rate and so it will have very modest impact. Its significance is confined to the signal: the Fed’s intention to clean out the excess reserves is clear, it is only the timing in question.
So neither the discount hike, nor the inflation numbers, justify any interest rate movement from domestic sources. That leaves international turmoil as a potential such source, but since those problems remain contained in Europe – at least for now – I see no justification for higher rates even from there.
One final note, on a different topic: I mentioned yesterday that JP Morgan analysts had developed a paper indicating that the returns on equity within banking would drop dramatically were all the regulations being proposed actually enacted. I derided the report based upon the notion that lower ROE’s in banking would be healthy. Another aspect of the report was the implied threat that banks would ‘have’ to raise prices to recoup the lost rate of return. In other words the analysts have the idea that there is a target ROE the market is looking for from banking and that renewed regulation would impose a cost the banks would have to recover. This is specious, for two reasons.
First: there is no benchmark ROE. And even were there, it would surely be re-calibrated at a lower level to accommodate the new regulatory regime. Suggesting that the banks would be ‘forced’ to raise prices is totally inept analysis.
Second: and returning to my argument of yesterday, were the old ROE targets to remain in force the better and more socially acceptable way of matching them, is to deconstruct the banks and stop the mingling of different RTOE’s that the big conglomerate banks now represent.
Overall that report sounds more like an attempt to fire off a cheap and shallow warning shot at legislators. They should ignore it completely.
