by Calculated Risk on 5/04/2011 03:30:00 PM

This is San Francisco Fed President John Williams' first policy speech: Maintaining Price Stability in a Global Economy. Excerpt on inflation:

[W]e’ve seen a very substantial pickup in prices for many energy, food, and industrial commodities. For example, in the past year, copper prices have risen 26 percent, crude oil 35 percent, and corn 75 percent.3 This is cause for serious concern. Sharply higher prices for many raw materials are driving up the prices of a range of consumer goods and services, including gas and food, and are pushing readings of overall inflation noticeably higher. The measure of prices that we at the Fed tend to watch most closely—the personal consumption expenditures price index—increased at a 3.8 percent annual rate in the first quarter of this year. This figure is well above the longer-term inflation objective of 2 percent, or a bit less, that most participants in our policymaking body, the Federal Open Market Committee, prefer.

This brings me to the second question: What is driving inflation so high? Well, as I mentioned, rising commodity prices, especially for food and energy, have been the culprit. Indeed, so-called core inflation, which strips out food and energy prices, was only 1.5 percent in the first quarter and averaged only 0.9 percent over the past four quarters. Now I know that core inflation has come under a lot of criticism. After all, people need to put food on the table and fill the tanks of their cars. I totally agree. It is the price of the entire household consumption basket of goods and services that we at the Fed care about in terms of our inflation goal, and that certainly includes food and energy. But, we find it useful to look at various measures of underlying inflation, including core inflation, to help us disentangle the various elements in the overall inflation picture. And statistical analysis shows that, over recent decades, measures of underlying inflation, such as core inflation, have been helpful in predicting the future course of overall inflation.

That brings us back to the question of why commodity prices have risen so much. Some commentators have suggested that the Fed itself has contributed to the run-up by keeping in place excessive monetary stimulus. According to this argument, the Fed’s policy of very low interest rates and sizable securities holdings are fueling speculation in commodities. Economic theory teaches us that lower interest rates will boost asset prices, including commodity prices, all else equal. But it is unlikely that this effect can explain more than a very small portion of the huge increase in commodity prices that we have witnessed. Economists at the San Francisco Fed recently looked at how commodity prices reacted when the Fed announced new policy actions to stimulate the economy. If Fed policies were responsible for the commodity price boom, then we should have seen those prices jump when the Fed announced more monetary stimulus. In fact, the researchers found that, if anything, commodity prices fell after new policy announcements and were not pushed higher by news about Fed policy. So, I don’t see any convincing evidence that monetary policy has played a significant role in the huge surge in commodity prices.

I see the real culprit as being global supply and demand. Rising commodity prices can be traced to the rapid rebound in the global economy in the past year and a half, led by robust growth in emerging market economies, which display a ravenous appetite for raw materials. For example, Chinese automakers sold some 18 million vehicles last year, a third more than in 2009 and more than any other country in history, including the United States. At the same time, as demand is rising, we’ve seen supplies of some commodities curtailed by weather or political disruptions. In recent months, turmoil in North Africa and the Middle East has reduced the global supply of oil and likely added a substantial risk premium to the price of a barrel of crude as well.

What do these fast-rising commodity prices mean for inflation for the rest of the year and beyond? I believe that the inflation rate will reach a peak around the middle of this year and then edge back downward. In other words, we are seeing a temporary bulge in inflation before we return to an underlying level of about 1¼ to 1½ percent annually. There are several reasons for thinking the inflation bulge will be short-lived.

First, commodity prices are not likely to keep increasing indefinitely at a rapid rate. Indeed, in recent weeks, prices for a number of commodities, including sugar and cotton, have fallen sharply. In addition, the prices of contracts for certain key commodities in the futures markets, such as crude oil, indicate that traders believe these prices won’t keep rising at double-digit rates. For example, the numerous supply disruptions that have pushed up prices of some foodstuffs, such as poor harvests in Russia and China, are not likely to be repeated. So even if commodity prices remain elevated, they won’t keep pushing up inflation.

A second reason for believing that inflation will peak and then trend down is that higher commodity prices generally represent only a small proportion of the cost of the finished goods American consumers buy. For example, corn and sugar make up only a fraction of the cost of a box of Frosted Flakes. Most of the cost comes from the labor involved in manufacturing, distributing, and selling the breakfast cereal, including paying for air time for Tony the Tiger. This means that large percentage increases in commodity prices typically translate into relatively small percentage increases in consumer prices. Of course, some goods, such as gasoline, have very high commodity input shares. But, in today’s economy, these are more the exception than the rule.

The stability of longer-term inflation expectations is a third factor that leads me to expect that inflation will start to ease later this year. It’s true that surveys show that consumers expect moderately high inflation over the next year. Households see gasoline prices going up and up and up, and, not surprisingly, they get worried about near-term inflation prospects. But medium-term measures of inflation expectations have barely budged. In other words, ordinary Americans agree that we are seeing a transitory rise in inflation. Those survey results reflect the fact that inflation has remained low and relatively steady for several decades and that the public believes the Fed is committed to keeping inflation under control. As long as household, business, and investor inflation expectations remain stable, then it’s unlikely that an inflationary dynamic will become established or that underlying inflation will jump sharply.

This leads directly to a fourth reason for thinking inflationary pressures will ease. The structural and institutional factors that led to a runaway inflationary spiral in the 1970s are largely absent today. Four decades ago, many labor contracts provided for automatic cost-of-living adjustments, or COLAs, which meant that higher prices fed into higher wages in a self-reinforcing feedback loop. Today, COLA clauses are mostly things of the past. Meanwhile, measures of wages and labor compensation, such as the employment cost index or average hourly earnings, have been increasing at an annual rate of only around 2 percent. When you factor in productivity gains, the unit labor cost of producing goods and services has been close to flat. These wage trends, which reflect the high level of unemployment in the economy, act as a powerful brake on inflation.

Before becoming the San Francisco Fed president, John Williams was a key economist at the Fed and his views on inflation will carry weight with other policymakers.