Inflation is not too low, it's just right

My sense of the consensus on inflation: it's very low, threatens to go negative; central banks seem powerless to boost it, but they need to keep trying because very low inflation is a sign that monetary policy is too tight and threatens widespread corporate bond defaults. The reality, however, is quite different. As I've been pointing out for a long time, if you strip out energy prices you find that the underlying rate of consumer price inflation has been running at a 2% pace for more than a decade. Nothing has changed of late. And there's no reason to think the current rate of inflation is too low.

The chart above says it all. It's the CPI ex-energy index, plotted on a log scale. It's been following a 2% growth rate ever since 2003. Whatever the Fed has been doing or trying to do, they have delivered 2% inflation.

The chart above compares the CPI to the CPI ex-energy. I've highlighted two periods when oil prices suffered a significant decline. I think the current period is playing out almost exactly like 1986. Headline inflation collapsed, but bounced back once oil prices stopped declining.

I note that in the late 1990s inflation was about the same as it is today (about 2%) yet that was a period of very strong growth (about 4% a year for several years). Low and stable inflation is a good thing. The problem today is that oil prices have been incredibly volatile. But as I pointed out the other day, the fundamentals of the oil industry have changed dramatically thanks to new drilling technologies. Governments no longer have the monopolistic control over oil supplies that they used to have. There's a new and important source of supply, and his name is Fracking. Oil prices are not going to decline much more than they already have. Oil demand is on the rise, and new drilling has been shut down dramatically—until prices start to rise again.

Oil prices are likely to be more stable in the future than they have been in the recent past, and that will allow the underlying trend of inflation—2%—to be revealed once again.

As an aside, I should note that the "core" rate of consumer price inflation is up at a 2.3% annualized pace over the past six months. Lower oil prices may be helping other prices to rise, because consumers have more money to spend on other things.

I'm once again skiing in Park City this week, so blogging may be light.