‘Nasty Surprises’ in Store for Economy: AEI’s Makin

The AEI economist views the recent jump in CPI inflation as a fluke that can’t be indicative of a trend in light of economic performance that has been weak because of fundamentals, not weather, which has been widely blamed for first-quarter weakness.

Makin cites another of fundamental factors, including a collapse of inventories (“companies that fear weak growth tend to run down inventories”) and wide-of-the mark consumption spending, expected to be a source of growth but which rather subtracted from it: “The contribution to consumption arising from Obamacare had to be revised down once it was discovered that signups for health insurance did not necessarily transfer into purchases,” he observes.

Another factor militating against a focus on inflation is that the recent spike was driven by the volatile food and energy sector that is rightly stripped out of more stable core inflation measures. There is nothing the Fed can do about drought conditions driving up food costs or disarray in Iraq that is causing oil price hikes.

Indeed, the Fed experimented with tightening during the OPEC energy crisis in 1974, thereby adding a demand shock to the already existing supply shock. The U.S. economy collapsed as a result, Makin recalls.

A still further reason for relaxing inflation anxiety is that “an inflation rate that stabilizes in the 1.5 to 2.5% range would be optimal for a U.S. economy struggling to” gain a growth foothold. Core inflation today stands at just 1.5%.

The economist worries that “inflation Cassandras” will do to the U.S. what the Bank of Japan’s overreaction did—lock “the nation into a 15-year period of stagnation after a 1997 tax increase”—or what the ECB’s current policy of allowing inflation to drop to 0.5% is doing—namely, keeping growth a 1.1% rate, thus risking deflation.

Prematurely hiking U.S. interest rates out of fear of inflation also risks a sharp collapse of markets, household wealth and the economy, he adds.

Makin laments that the Fed has said “virtually nothing” about weak GDP growth, merely hinting that it might further delay the first expected interest rate hike.

“Markets have set that date at about mid-2015,” he says. “It will no doubt slip further to 2016, given the weakness of the U.S. economy.”

But the AEI scholar argues the Fed could be more helpful but cutting the inflation and rate-hike talk altogether and start considering policy that might promote growth.

That could “include purchasing a wider range of assets than those currently being purchased under the Fed’s quantitative easing program,” he writes.

“But before that happens, the Fed will have to stop dreaming about 3% growth and wake up to the reality that 2014 will be a slow growth year,” Makin concludes.