Inflation as a Mouse not being Chased

Here is a graph that shows the fall of core PCE inflation from its peak in 1981 to the present. (link to quarterly data)

Inflation has fallen with stable swoop downwards. We are currently at about the 0.1 mark on the x-axis showing a core PCE of 1.6% on the y-axis.

The graph implies that inflation is a long way from returning back to the conditions when inflation was high. So the x-axis must tell a story of inflation. What is on the x-axis? Let's look at its equation...

Profit per unit of real gross value added of nonfinancial corporate business: Corporate profits after tax with IVA and CCAdj (unit profits from current production) - (60%*Fed rate +40%*10-year treasury rate)

The equation basically takes the real after-tax profit rate and subtracts a measure of the nominal rate which blends short-term rates with long-term rates.

When nominal rates are high, we would expect inflation to be high too. Why? Well, when inflation goes high, nominal rates go high to control inflation. But there is more to the story. Nominal rates can float inflation upwards, or knock it down depending on how strong nominal rates rise.

Model of Inflation & Nominal Rates (Cat & Mouse Chase)

Here is the model for the graph. The upsloping red diagonal line is the real cost boundary. Corporations want to be to the right of this red line. Then their after-tax profits are positive and the economy can grow or stabilize. But to the left of this red line, corporations are forced to contract from negative after-tax profit rates.

Net Profit rate = real profit rate - nominal rate + inflation

If corporations can keep prices rising ahead of nominal rates, then they can deal with profit rates being squeezed. But if the central bank does not like rising inflation, nominal rates will get aggressive and can force net profit rates negative. This happened in the Volcker recession. As soon as Volcker jacked up the Fed rate, the data points were pushed to the right of the red diagonal line and the recession ensued, which brought down inflation.

In the model above, the black arrow shows that inflation rises when nominal rates are rising but not strongly enough and inflation can keep ahead of it. Then when nominal rates get aggressive, we follow the dashed red arrow to the left side of the real cost boundary. Then we follow the green arrow down, where inflation is dropping and nominal rates can follow them down.

I view the dynamics like inflation is a mouse and nominal rates are a cat. If the mouse can stay ahead of the cat, the mouse will keep moving in the same direction. If the cat can get ahead of the mouse, the mouse will turn around and head back in other direction.

Currently we are far from the red diagonal line. Real profit rates are at historic highs and nominal rates are low. Yet, people think that inflation will shoot up soon because nominal rates are going up and profit rates are coming down. So corporations will have to react with price increases.

Conclusion

However, real after-tax profit rates will have to come down much farther, and nominal rates will have to rise much further. My view is that real after-tax profit rates may actually rise if corporate taxes are slashed last year. As well, the Fed will most likely raise the Fed rate slowly as Stan Fischer has stated.

Since the model above sees very low inflation pressures for years, the Fed will be justified in raising the Fed rate slowly. Ultimately, bond yields will come back down from the recent increases.

Comments

[Alan Robert Ross]

In your conclusion, do you really mean, if corporate tax rates are going to be raised NEXT year?

"My view is that real after-tax profit rates may actually rise if corporate taxes are slashed last year."

[Edward Lambert]

Yes... it should say NEXT year.

[colt g]

Hi Edward, do you have any insight into a comparison between 1984-86 and 2014-16, per the UT Index chart? For instance, my first thought is oil prices.

Thank you for all your research.

-C

[Edward Lambert]

HI Colt,
84 to 86 was a slowdown. Interest rates rose a bit, but the major part of that was the natural real rate had risen. And the short-term real rate had gone from negative to positive. The effect was to slow things down.
That is not happening now. The real rates are falling.