Inflation Risk? Nah – I’m More Concerned About Janet Yellen!


Inflation Risk? Nah – I’m More Concerned About Janet Yellen! Sara Grillo, CFA, President at Grillo Investment Management

Those who fear high inflation should consider two key economic factors that are commonly ignored: capacity utilization and monetary velocity. Both indicators do not warrant concern at their current levels. Given the concurrent failure of policymakers to stimulate demand and the semi-invalid Phillips Curve, there’s not a high likelihood that inflation will hike significantly in the near future.

At the present moment, inflation is held in check by lower than normal capacity utilization, which expresses the percentage of a firm’s actual output relative to its hypothetical total output. Total industry capacity utilization is currently a bit more than 79%, according to the St. Louis Fed. It dropped as low as 67% in June 2009, the depths of the crisis. Said differently, at that time the US economy was producing only two thirds of what it could have. Low capacity utilization means there is plenty of room to increase profit margins, because firms can hire workers without raising wages. But at full capacity, more output will lower margins because wages have to rise. At the current level of idle capacity, there’s not enough competitive pressure for labor. We should worry about inflation when capacity comes back to about 82%.

Velocity of M2 Money Stock, or the number of times one dollar is used to buy a good or service, was just below 1.5 for Q4 2014, also from the St. Louis Fred. Although this marks a decline from 2011’s dismally low levels, money used to change hands much faster a decade ago.

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According to these indicators, we’re unlikely to see inflation for a while. Even if monetary velocity were to accelerate, wages won’t rise because of high idle capacity. Moreover, policymakers have been unable to solve the problem of stimulating demand. Look at how hard they’ve tried. Operation Twist, the government’s attempt to tamper with the credit system, was extended. Another thwarted attempt was quantitative easing, which flooded the banks with massive amounts of liquidity but accomplished little else.

Unfortunately, the reason people aren’t pouncing is not that interest rates are too high, or that there’s not enough liquidity. Lower interest rates won’t help; they’re already low enough and the money isn’t moving. The real reason is too much of the US population remains underemployed. Yes, there has been job creation but they haven’t been high wage positions. People are doing what they can to pay their bills for a fraction of the salary they rightfully should be earning.

Keep in mind that the government has tried unsuccessfully to create inflation for years, and has failed because it has lost the power to stimulate demand. There aren’t that many levers left to pull. We can’t push rates any lower. The other two options are lowering taxes or injecting more money into the system through QE. Regarding the latter – been there and done that! And given the political regime in place, how likely is a tax cut? See, as I said, there’s nowhere else to go.

Given the lack of a viable stimulus and the partially functional Phillips Curve, I’m not convinced that the US is going to be turning into the next Weimar Germany anytime soon. The bigger concern for US investors should be Janet Yellen, which will be the subject of tomorrow’s blog. Stay tuned! To receive my blogs automatically, please follow me on Twitter @grilloinvest.

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